Sustainalytics Case Study
FinTech: The domain of ESG Investing with particular focus on Sustainalytics
"You can do well by doing right" David Katz, Chief Investment Officer, Matrix Asset Advisors
"The hardest part is predicting the future. You can have a company that looks great up to a certain point, but all of a sudden implodes. But that's where ESG will help" - to avoid traps. Savita Subramanian, head of global ESG research at BofA Securities
Overview and Origin
Chicago-based Morningstar, Inc. has long been a fixture in the investing community, providing independent investment research. In 2016 they took locked in their lead position by establishing the Morningstar Sustainability Rating. This rating makes it possible for the investment community to screen portfolios against specific around environmental, social and governance (ESG) information. In 2020 Morningstar increased their ownership of Sustainalytics from 40% to 100%.
Sustainalytics was created by the merger of Jantzi Research, founded by Michael Jantzi in 1992, and European firms that were engaged in the same wrok. After that merger in 2009, Sustainalytics used its global reach to grow and expand. In 2017 Morningstar acquired 40% of Sustainalytics, which was reporting billings to institutional clients of $ 50,000 to $ 500,000 per year. In exchange, Sustainalytics' employee team of 320 provided evaluations of 6,500 companies.
Jantzi struggles in the early years with the black-and-white mindset of good companies vs. bad companies - too broad of a brushstroke to be of use. He needed to incorporate a more realistic framework, one that incorporated both 'good' practices and the 'value' goals of investors. Along with the ESG sector, his thinking morphed over time to a position that seems a huge congruence between those values.
* "The client base has gone from being values-driven to being value-driven," says Jantzi.
He is referring to the fact that good corporate governance (which meets ESG criteria) also tends to result in better values for investors.
Costco has tripled its share price over the past 10 years, Wal-Mart is up only 50% - that's because the long-term, well paid employees of Costco deliver more growth.
* "We're not expecting perfection," Jantzi says, "We're expecting the use of best practices."
As of 2017 the main competitor of Sustainalytics was MCSI (Morgan Stanley Capital International), which had nine times the number of employees as Sustainalytics and an enterprise value to $10 billion. In 2019 Sustainalytics acquired Stockholm-based GES International (specializing in engagement, screening and fiduciary-voting services for institutional investors), bringing their employee total to 600 in 17 cities around the world, and their client base to 700 institutional investors.
Landscape
Moving to a more sustainable world has gained urgency recently, both in the US and globally. In her role as interim SEC chair, Allison Heron Lee has strongly encouraged the investment community to adopt ESG principles, including by established a "Climate and ESG Task Force" in March 2021 and the appointment of a Senior Policy Advisor for Climate and ESG.
Much of this is driven by steps the EU has been taking over the last decade, in pursuit of the twin goals of embedding into the financial system itself an awareness of sustainability concerns, and to actually impact the flow of capital towards investments that meet sustainability goals. These steps have resulted most recently in the EU Sustainable Finance Disclosure Regulation (SFDR), released in April 2021. And one of the major aspects of these new regulations are Principal Adverse Impacts (PAIs). PAI's are a concrete measure of the negative results caused by a specific good or service, in relation to the ESG areas including:
[ ] Environmental [ ] Social [ ] Employee [ ] Human Rights [ ] Anti-Corruption [ ] Anti-Bribery
In order to present themselves in the best possible light, companies will need to not only disclose information about PAI-related decisions, but will need to make those decisions themselves as constructively as possible.
requires change in the overall financial system. There needs to be transparency to the extent necessary for investors to have adequate information for their decision-making. Various groups in the investment sector are taking similar but distinct approaches to add ethical considerations into investment-related decision-making. Three main approaches are ESG (Environmental, Social and Governance), SRI (Socially Responsible Investing) and Impact Investing.
Ethically-based investing infuses the traditional metrics of risk and return with more nuance. This includes taking into consideration non-financial risk like regulatory violations and harmful product exposure, as well as renewable energy investments and a broad range of social development projects. Minimalist-style investing is focused on risk mitigation, avoiding such sectors as tobacco - this is also known as SRI Additional SRI screens include production of weapons and/or defense sector activity, human rights and labor violations, and terrorism affiliations. Intermediate application of ESG principles includes 'ESG Alpha' which attempts to identify high-potential opportunities, as well as trying to minimize ESG problems while also maintaining value. The maximum application of ethically-responsible investing - impact investing - would be defined as philanthropy itself: investing in business or organization in order for them to engage in a program or process that positively benefits society, with no expectation of financial return.
ESG investing increases the amount of information required by the investor. Diederik Timmer, executive vice president with Sustainalytics explained the informational scope, "we look at a company's business models and where they operate geographically and assess what ESG factors they're exposed to. Stock ownership carries with it a large quality of data points", explains Conor Platt (founder and CEO of Confluence Analytics), " ... and for investors, ESG metrics are the best way to assess intangible risk." This magnifying glass is being directed not only at stocks, but bonds as well. ESG aesthetics fit especially well with bonds, since "muni bonds are the original impact investment instrument," as Judy Wesalo Temel, senior vice president and director of credit research with asset manager Fiera Capital explains. Muni bonds.."build schools, roads, hospitals - all sorts of things that improve the human condition."
Marco Silveira, financial advisor with Toler Financial, recognizes the challenges inherent within ESG ratings, including the presence of subjectivity and a lack of consensus around the relative importance of various criteria. He nonetheless expressed great optimism as well, "Why we're excited about ESG is that, as the market comes to integrate and understand the mechanics of these types of risk, it will lead to increased valuations and prices for the companies with the lowest risk. The world could ultimately be rewarding companies for better behavior and better stewardship of these important risks, and untimately, higher valuations will result in a lower cost of capital."
In fact, the S&P 500 ESG Index has outperformed the S&P 500 by 2.21% since launch. The covid pandemic was a huge accelerating factor in ESG investing. In July 2020 record inflows into ESG funds reached $1 tr AUM, and by February 2021 $ 17 trillion AUM (or 1/3 of total invested) was managed under an ESG or sustainability mandate of some type - a 43% increase in less than two years. Continuation of that trend would result in half of all assets in the US that are professionally managed being under an ESG mandate by 2025.
Many investment firms do their own ESG research. Calvert Research and Management, for instance, has been in the business of sustainable investing since 1976, and introduced the first social index in 2000. In 2017 Calvert was purchased by Eaton Vance, and in March 2021 Morgan Stanley acquired Eaton Vance. Anthony Eames, vice president and director of responsible investment strategy at Calvert explained their ESG research process in March 2021 as starting with ESG data from multiple providers (since each structures their data somewhat differently), and then they add their own custom indicators to come up with a proprietary research offering. They apply their own longstanding principle definition - the Calvert Principles to compare companies' managerial strength.
Historically in fact, there have been conflicts of interest between research and investment banking units. In A Random Walk Down Wall Street, Burton G. Malkiel points out the examples of Trump's Taj Majal bonds downgraded by analyst who was fired for doing that, the unrelentingly positive consensus opinions regarding British Petroleum after the Deepwater Horizon explosion and oil spill; and the ongoing bias towards "buy" advice. And in 2003 a collective of 10 securities firms paid $ 1.4 billion to settle a lawsuit brought by FINRA, SEC and multiple other parties, in regard to the relationship between their research activities and their investment banking clients. Those firms included Morgan Stanley & Co. The Sarbanes Oxley Act of 2002 addresses these conflicts by establishing guidelines around the relationships between investment research and investment banking divisions, and other provisions.
Ongoing ESG reporting challenges to be addressed include:
- [ ] increasing consensus around metrics and criteria - [ ] increasing access to consistent, complete information that meets the various criteria - [ ] gaining access to sufficient resources with which to gather the information and provide the analysis
One way companies can assist in meeting these challenges is to increase and improve their own sustainability reports. Some frameworks to apply in that process include the Global Reporting Initiative's Sustainability Rating Standards, and the guidance from the Sustainability Accounting Standards Board (SASB).
Results
Sustainalytics - along with MSCI and Trucost - are established leaders in the provision of ESG data, and are expected to continue to dominate their area (including with further acquisitions). MSCI was originally Morgan Stanley Capital International, fully independent since 2009. Trucost is a division of S&P (Standard & Poor's) Global, and gathers research on cost risks centered around carbon and environmental data particularly. Reponding to industry preference for transparence, these major providers are starting to make their information available to the public. Sustainalytics launched a new iteration of its research/ratings package in 2018, which was publicly available through Yahoo!Finance. MCSI provided its ratings to the public as well in 2019. And in 2020 Sustainalytics published their ratings of 4,000 companies on their website for public access. This public listing provided a rating within the following risk spectrum, which facilitates comparisons even among companies in different industries:
- severe - high - medium - low - negligible
Sustainalytics continues to expand operations, and as of 2020 reported that they provide data on 40,000 companies worldwide and ratings on 20,000 companies and on 172 countries. Morningstar and Sustainalytics provide support for the entire investment community, including individual investors, advisors, private equity firms, asset managers and owners, plan sponsors and credit issuers. Morningstar provides investment management and advisory services through subsidiaries, totaling approximately $ 233 billion in assets as of December 2019.
Recommendations
Currently Sustainalytics is focused on providing information to the investment sector itself, and - to a limited extent - the public, with their newly expanded public listing on their website.
It has long been a maxim for the individual investor to invest in what you know. Invest in companies you have actual lived experience with, companies in your community, companies that make products you use.
The public increasingly expects to have information at their fingertips - on their phone - for every aspect of their lives. And in fact investment ratings are started to be provided via mobile apps. There are several stock-trading mobile apps on the market, including one from Merrill Lynch called Merrill Edge that does include ESG ratings.
My recommendation is three-fold - that Sustainalytics increase their scope to include individual investors as an information market, that they provide information at a more detailed level, and that they produce a mobile app on which to access that info.
I'd like for the consumer to be able look up a company or even a product, and receive information about any PAIs reported, and more recently about the ESG rating for that query.
References
Strauss, Lawrence C – Here’s How to Marry ESG and Dividends and 5 Picks for a Start – Income Investing. Barron’s September 6, 2021 p 37.
Morningstar Sustainability Rating – Methodology. Morningstar Research. October 31, 2019. Version 1.2.
Baldwin, William - This Man Will Purify Your Portfolio. Forbes. April 3, 2017.
Sloley, Chris – ESG research giant Sustainanalytics purchases engagement group. CityWire Selector. January 9, 2019.
Shaikh, Niloofer – Morningstar acquires balance 60% state in Sustainanalytics. Seeking Alpha. April 2020.
Nason, Deborah – Here’s how companies factor in environmental, social and corporate governance concerns. CNBC. December 29, 2020.
MacMahon, Simon – The Challenge of Rating ESG Performance: An expert explains what’s involved. Harvard Business Review. September-October 2020.
Jones, Natasha – Climate Fin Tech: The startups helping banks to overcome the ESG resource gap. Octopus Ventures. February 12, 2021.
Sustainalytics provides public access to ESG ratings – the research firm aims to increase transparency of ESG risks within companies. IE Staff, Investment Executive. July 23, 2020.
Sustainalytics makes its data on 4,000 companies freely accessible. Reuters staff, Reuters. July 23, 2020. Morningstar to Acquire Sustainalytics and Expand Access to ESG Research, Data and Analytics for Investors Worldwide. Morningstar press release April 21, 2020.
Calvert: What’s ahead for responsible investing? The top Overall Small Company believes 2021 could be a pivotal year for ESG investing. InvestmentNews Content Strategy Studio. Investment News. March 11, 2021.
MSCI Company Profile. Investopedia.
Trucost Climate Analytics and Environmental Data now Integrated into the S&P Global Market Intelligence Platform- Users can now enhance their sustainability analysis and workflow with access to climate and environmental datasets covering over 15,000 companies - PR Newswire. September 21, 2020.
What is the Impact of the EU Sustainable Finance Disclosure Regulation (SFDR)? S&P Global Market Intelligence Blog. David Henry Doyle. April 1, 2021.
Zhou, Michelle - ESG, SRI, and Impact Investing - What's the Difference? Investopedia. June 20, 2021.
Climate Gets Heated at the SEC Burr-Forman Blog, 3/5/2021.
Climate, ESG Top Lee’s List at SEC Burr-Forman Blog, 3/16/2021.
Malkiel, Burton G -- A Random Walk Down Main Street. W. W. Norton & Co, New York, 2020. P 169-172.
Ulick, Jake – Wall St. deal is finalized. CNN Money. April 28, 2003.
U.S. Securities and Exchange Commission v. Morgan Stanley & Co, Incorporated (2003). sec.gov/litigation/complaints/comp18117.htm.
Overview of the Sarbanes Oxley Act. Financial Web-Investing-Investing Basics.
Neal, Ryan W. Merrill Edge adds ESG scores to client dashboard – Update provides visuals to simplify portfolio analysis and performance review. Investment News. February 12, 2018.