Several articles over the past few years have made the case that inconsistent sustainability ratings make things difficult for companies and investors. For instance, a June article from Financial Express contended that investors that rely on sustainability ratings from any single rater “may be less protected than they think.” Another recent article noted that the lack of standardization in sustainability ratings resulted in companies being asked to fill out an increasingly burdensome load of questionnaires from raters. Another article questioned the usefulness of sustainability ratings due to a lack of consistency across different ratings providers.
There are a few themes that emerge from this literature. One relates to burdensome reporting for companies. Another is about the usefulness of ratings in investment markets. Much of this literature concludes that the lack of consistency across ratings providers is impeding investors and financial markets. We disagree.
Let’s start with the easy thing: we understand the frustration companies have with multiple questionnaires. As an investment company, we get a lot of requests for information too, and it does seem like the number and depth of those questionnaires are increasing. It can be time-consuming to fill them out, and sometimes even frustrating if the questionnaires are structured in ways that make them difficult to understand and answer. There’s an alternative to that: mandatory reporting.
There are a lot of questionnaires addressing sustainability because most companies are not required to report it. This is similar to the situation before the stock market crash of 1929, and before we had laws requiring standardized reporting of financial information. The SEC’s What We Do webpage explains this nicely.
Mandatory reporting gave investors the ability to capture the potential of capital markets without the peril of undisclosed risks. If this is sounding familiar, consider why we passed Dodd-Frank and how little we knew about the risks of things like collateralized debt obligations and other complex financial products. While the parameters of sustainability have not historically held the same potential for economic speculation and the pain of popped speculative bubbles, it is abundantly obvious that mismanaging things like environmental impact, safety, and discrimination can have a profound and negative impact on company value, and thus investor value: think BP, Massey Energy, Uber. If investors had to create their own financial pictures of companies, there would be many more questionnaires arriving in company mailboxes than there are now.
So investors do need reliable, consistent information on sustainability to be conversant with value-destroying risks, just as we need good financial information. But what we don’t have, on either the financial or the sustainability side, is one single method for assessing this information.
The second theme in the literature is that rating inconsistency is difficult for financial markets to incorporate and for investors to use, and that could explain some of the reluctance of some investment practitioners to fully integrate information on sustainability into investment decisions. We emphatically reject that notion. Financial markets are full of ratings, and there is a lot of inconsistency within them. That can be a source of insight and innovation, but it has never been a ball and chain.
From an investment perspective, the purpose in using sustainability information in portfolio management is exactly the same as the reason for using financial information: to provide insights to help identify companies that are better positioned to add value or reduce the risk of the portfolio. It’s not uncommon for traditional stock ratings to disagree. One firm may rate a company a strong buy, while another says hold or maybe even sell. How can that happen, when all the analysts have access to the same trove of financial data? It happens because data does not equal analysis, and analysis is required to create a rating or make an investment recommendation.
Data is the collection of facts about a company that analysts use as their analytical idea warehouse. Analysis creates information out of facts. We need this information to create estimates of companies’ future potential to add value, which in turn is used in making a recommendation regarding the stock’s place and weight in a portfolio. A rating is a judgement, based on experience, skill and insight on the part of the analyst, synthesizing their insights gleaned from analysis of the data.
Ask any expert in sustainability what “sustainability” is, and you’re likely to get a fairly broad, comprehensive definition like “Development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” It should not shock anyone that there’s no simple cookbook for how to create it, in society or in a portfolio.
Different people emphasize different parameters of sustainability, but lack of agreement does not signal that there is wrongness in any of it, just a different take on the importance of different variables.
There is no one perfect way to judge sustainability in a company, any more than there is one perfect way to figure out which companies are going to add the most value to a portfolio. These are judgment calls, based on knowledge, skill and experience. There are analysts who are experts in assembling the relevant facts, creating useful information with it, and giving meaningful ratings to companies for their performance on the sustainability metrics most relevant for each specific company, just as there are financial analysts who have great skill in identifying the companies best positioned to outperform their peers based on financial information.
The real opportunity lies in the full integration of sustainability analysis or ratings in the financial analysis of a company and the characteristics of a portfolio. What insights are gleaned from sustainability analysis, a sustainability rating or components of a rating that might provide the portfolio manager with unique insights and an edge in outperforming? How is the sustainability profile/rating reflected in the current valuation of the stock? How does the inclusion of a proprietary sustainability rating impact the risk profile of a portfolio? These are just a few of many potential insights that might be gleaned by integrating a unique, differentiated sustainability rating in stock selection and building a portfolio.
The idea that ratings need to be consistent in order for markets to function is misguided. But the idea that the analysis should be based on a set of common facts does have merit. What we need is a mandatory, consistent reporting framework that companies all understand and use, so that analysts can use their interpretive skills and knowledge to create value. What we have on the financial side of the equation is financial reporting, guided by standards like US GAAP and IFRS. There are standardized reporting protocols in the sustainability world, like the Global Reporting Initiative and the Sustainability Accounting Standards Board, but they are not mandatory. So there are some companies that report, and some of those report in ways that comport with these standards—but that’s a minority of companies. We do need standardized sustainability reporting. But that is a very different thing than standardized sustainability ratings, just like financial reporting isn’t the same thing as financial analysis. Analysis gives those with deeper insight and greater knowledge an edge, and helps stimulate continual advancement in providing useful ratings. In short, it’s a source of competitive advantage and innovation.
Think of sustainability analysis the same way you think of financial analysis. Different approaches to the same multifaceted problem is a source of innovation, a way that smart and insightful people can distinguish their work. It’s not a ball and chain, it’s a springboard.