The Power of ESG Ratings in Capital Allocation

How to determine the most relevant ratings for your organization
The Power of ESG Ratings in Capital Allocation
Publ. date 20 Mar 2024
There is growing recognition that ESG factors can have a material impact on a company’s financial performance, risk profile, and long-term sustainability. One of the ways in which investors factor sustainability matters into their decision-making is through ESG ratings and benchmarking, such as S&P Global’s Corporate Sustainability Assessment (CSA), Sustainalytics ESG Risk Ratings or MSCI ESG Ratings. This article outlines the benefits of participating in ESG ratings to improve access to capital and provides guidance on how to select the most relevant ratings to participate in.

The paradigm shift towards integrating sustainability into financial decision-making

Having emerged in the 1960s and mid-2000s respectively, socially responsible investing (SRI) and impact investing were deemed to be niche interests for a long time and only of importance to investors that wanted to ensure their investments were aligned with their ethical values. The focus was on excluding companies involved in controversial activities (e.g., tobacco, weapons) rather than on integrating ESG as a core part of financial analysis.

With the 2015 Paris Agreement and the adoption of the UN Sustainable Development Goals (SDGs) highlighting the importance of sustainable investment in combination with the mounting evidence that ESG factors could significantly affect companies’ risk and return profiles, interest in ESG integration grew beyond ethically motivated investors to include mainstream financial institutions in the last 10 years. Indeed, the NYU Stern Center for Sustainable Business’ assessment, analyzing more than 1,000 studies, showed that roughly 60% of research papers found a positive correlation between ESG and financial performance.

Today, the consideration of sustainability aspects in financial decision-making is reflected in a variety of legislations and regulations such as the Sustainable Finance Disclosures Regulation (SFDR), the EU Taxonomy for sustainable activities and the Corporate Sustainability Reporting Directive (CSRD). They serve as key instruments in the EU’s strategy to achieve sustainable growth and aligning financial systems with the goals of the European Green Deal by providing the critical data and insights needed for evaluating, selecting and managing investments while considering ESG practices. The alignment of ESG ratings and the aforementioned legislations/regulations is therefore increasing as well.

ESG-focused and green investing has faced some backlash in the post-covid era, especially in the United States, mostly due to the inconsistency and lack of standardization across ESG rating systems, leaving room for different interpretations. Although the impact of ESG ratings on access to capital can vary by industry, region, and the analysed ESG factors, ESG ratings remain one important component of how investors take decisions. It comes therefore not as a surprise that a study conducted by Capital Group found that ESG adoption in investment decision continues to increase with almost 90% of surveyed investment professionals considering ESG factors.

Why do investors consider ESG insights in their decision-making?

ESG factors represent material risks and opportunities that can affect a company's value. For example, exposure of assets to physical climate risks, e.g. extreme weather events such as storms or floods, or chronic climate change phenomena such as sea level rise, regulatory risks in case of non-compliance such as human rights violations, or reputational risks in case of governance mismanagement or scandals such as tax evasion.

ESG ratings help investors assess how well companies are managing these risks. On the other hand, the consideration of ESG ratings may help to identify companies that are well-positioned to leverage opportunities in the “green economy” and that are able to fulfil the increased demand for ESG transparency.

Additionally, strong ESG performance can correlate with superior financial performance, including higher returns on equity, lower costs of debt and equity, and better resilience during market downturns. As a result, ESG ratings have become valuable tools for identifying companies that are likely to outperform over the long term. There is a growing conviction among investors that strong ESG practices are indicative of excellent management and long-term strategic thinking.

The value of investing resources into ESG ratings to attract investment

Participating in ESG ratings can be a time- and resource-consuming task. However, a successful participation in renowned ratings and benchmarkings also offers companies the opportunity to reap the rewards of their labor, including:

Attracting broad investor base: Companies that showcase good ESG performance are more likely to meet investor and regulatory requirements and can benefit from a strengthened brand reputation which attracts customers and investors alike.

Lowered cost of capital: Investors perceive companies that perform well as lower risk, partly because good ESG practices can mitigate environmental, social, and governance-related risks. Lower perceived risk can translate into lower required returns from investors (the minimum return needed to justify investing in the asset) reducing the cost of equity, providing well-performing companies with a financial advantage.

Increased access to ESG funds and sustainable finance opportunities & reduced cost of debt: Companies with strong ESG ratings can become eligible for ESG-linked financing products, such as sustainability-linked loans and green bonds. This involves aligning the company's ESG performance with the eligibility criteria of these financial products and demonstrating continuous improvement in ESG areas. Lenders may offer more favourable borrowing rates to companies with perceived lower risks and long-term viability due to the recognized link between strong ESG performance and financial stability.

How to know which ESG ratings to focus on to successfully attract investments?

The sheer never-ending jungle of ESG ratings and benchmarking available requires organizations to take a step back and prioritize which ESG ratings would be most beneficial for them. Please find some actionable tips on how to determine the most relevant ratings for your company in the download attached to this article.

Do you need further assistance in picking the right ESG benchmarks and succeeding at them?

Determining which ESG ratings are most beneficial and relevant for an organization can be a challenge and should be decided on a case-by-case basis. Please contact Johana Schlotter at johana@finchandbeak.com or +31 6 28 02 18 80 to discuss how we can assist you.

About Rachel Wilbertz

Ambitious professional aiming to promote corporate sustainability, sustainable development, and environmental justice. | rachel@finchandbeak.com

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