Ask your shareholders which ESG yardstick to use

MSCI is one of the leading providers of ESG ratings, which aim to measure a company's resilience to long-term, financially relevant ESG risks. In this interview from the Nordea On Your Mind, "ESG: Reaping the rewards," Nordea's Johan Trocmé asks MSCI's Remy Briand about the company's fast-growing ESG business and what to expect from the ESG ratings landscape going forward.

JT: Could you tell us in a few words about MSCI and your business today? How big has your ESG ratings business become?

RB: MSCI as a company has roughly USD 1.7bn in revenue. Our mission is to help investors build better portfolios for a better world. MSCI's ESG business currently generates revenues of approximately USD 250m, of which USD 150m is related to ESG ratings and climate solutions, while the rest is related to our indexes. We have seen a 30% compound annual growth rate over the last decade in our ESG business, so it has been – and remains – the fastest-growing area within MSCI.

JT: How did it start? Where did it come from, looking at the journey you have made over the past ten years?

RB: We became involved in the ESG business through the acquisition of the risk analytics provider RiskMetrics in 2010, which had, in turn, acquired two smaller players, Innovest and KLD, the year before. I led and executed what is today called MSCI ESG Research through the merger of those two entities. At that time, we had a clear vision that we wanted sustainability to be something that every investor would consider in their overall portfolio construction, and that MSCI could offer a solution that met their needs. At this time, we did not regard this as a marginal activity. We wanted to resolve the long-term assessment of both risks and opportunities related to ESG. We therefore built, or perhaps rather extended, the methodology, the data and the solutions to ensure this was something any investor could do at scale across all their investment portfolios.

JT: How would you describe the business model of your business within MSCI compared to the typical business model of the credit rating agencies?

RB: It is a very different business model in the sense that users of our ratings are also the ones who are subscribing to the ratings. We think this is a good way to align the incentives of the provider and the buyer. Thus, it is very different to credit ratings, where the issuer pays for the rating and investors use the end result. This, as a subscription-based activity, is relatively straightforward. Our model has been like this from the beginning.

JT: Do you license the use of the rating to the issuers as well? As some other providers do?

RB: Yes, what we do is essentially the product. This is the rating, the research associated with it, and all the data. These are the components that lead to the rating, so there is a lot of data. This is sold mostly to investors, but if a company wants to use it for primary benchmarking purposes, then we sell that as well. Separately, we always provide all the information free of charge to the companies so that they can review it and provide feedback, comments, etc.

What we don't do is provide advice on how to improve their rating, because we think it's a very difficult activity for us to do without any perception of a conflict of interest. We also work a lot with investment banks and strategy consultants who are able to give advice. But we don't do it directly ourselves.

RB: A decade ago, the response rate from companies was extremely low, perhaps 10-15%. Today, if you look at the constituent companies of the MSCI World Index, comprising large and mid-cap companies in developed markets, the response rate is roughly 75%. With three-quarters of the companies in the MSCI World Index engaging with us on their ESG rating, it would indicate that these companies are now paying detailed attention to ESG issues.

JT: When you look at demand for ESG ratings, would you say that it is heavily biased towards the investor side, or would you say that there is also demand driven by the issuer side, or both?

RB: I think it is both. The engagement rate shows there is a lot of interest from corporates now. The nature of their interest is different; the corporates want to improve and then market their ESG credentials. Investors want to have an ESG assessment for very obvious reasons related to their policies and investment strategies.

Our business, by its nature, is more geared towards investors. But ESG ratings are absolutely something which both corporates and investors are extremely focused on. A decade ago, we were almost begging to discuss this topic with corporates in order to rate them accurately. Today, most of the discussion is about implementation. So it's a different mindset now. The acceleration in corporate engagement has been even more pronounced over the last three years, and last year was in a league of its own.

JT: What are the demand drivers for ESG ratings?

RB: The ultimate driver is attitudes in society, which have changed and have translated into a very strong focus on ESG. This has been reflected in strong interest in having ESG options for savings and investments by high net worth individuals and retail investors, which have been picked up by asset managers. On the institutional side, the board overseeing a pension fund typically represents general society and its interests.

We have been very focused on resolving how to assess ESG issues which are essentially long-term risks, which may have been ignored by many investors. If you are a trader and you have an investment horizon of ten minutes, climate change is probably not the most important aspect of your trading strategy. But if you are a pension fund, or even if you are an individual saving for retirement, your investment horizon is 20 years or longer. Then, climate change becomes a critical issue.

It is all about integrating ESG into investment processes, allowing individuals or pension funds to ensure that their agent, the asset manager or the traders take into account what matters to the end investors.

JT: It sounds like these drivers are quite structural and long-term in nature, and that there is not really a sense that this is a temporary fashion or a fad?

RB: No, absolutely not. The trend is clearly towards wealth managers' offerings to be, by default, ESG and climate-oriented, and your clients will have to raise their hand and say no thanks if they want non-ESG investment funds. Corporates are affected by the same underlying driver of changing consumer behaviour. Therefore, if you are either a company or an investment manager and you want to integrate sustainability as part of your overall strategy, you will change your product range to capture those behavioural changes.

Another strong driver is regulation, which drives changes in corporate behaviour. As a company, you need to ensure you can keep your licence to operate and you need to be perceived as taking a long-term sustainable approach.

JT: There are big differences in the focus on sustainability among various regions of the world. We are not at the same starting point in North America as in Europe or in Asia. How do you see those differences and do you think they will persist?

RB: Historically, there has been more focus in Europe on these issues, but that doesn't mean that the other regions are not very focused now. In Asia, for example, Japan went from completely ignoring the ESG topic five years ago to now being quite systematic, across pension funds and asset managers, in integrating ESG. To a large extent, this is owing to GPIF, the Japanese state pension fund – the biggest in the world – adopting ESG. So things can change quite rapidly, and in particular we are seeing a major change in approach now in the US, where the regulatory framework has been less supportive up to now, related to the new Biden administration. I would therefore expect a significant acceleration there.

JT: How would you compare MSCI's ESG ratings to what other providers offer? Is there a high degree of similarity or are there significant differences in approach?

RB: There are still quite a lot of differences between the various providers. They are different in a few ways. First, they are not all trying to resolve the same problem. We have been very clear in our rating that we're trying to measure long-term risks that are material to industries or companies, so we have this materiality focus. It translates mostly into selecting five or six issues that we think are the most relevant for the company. Any other approach is more normative, trying to measure what is good or what is bad. Just to illustrate the difference, take, for example, water management. If you are a bottled water company and you don't have access to water, you are out of business. So that is a material issue. If you are an advertising company and you reduce water use in your office, it's a good thing but it is not a material issue in the context of a sustainability assessment. That difference in approach goes a long way towards explaining why you may have very different results for ESG ratings.

The other key category is the level of reliance on self-reported information from companies – or even worse, surveys. So, if your only input into the ESG rating is a survey or what the company puts on its website or in its corporate social responsibility (CSR) report, then by definition you're being greenwashed. This is not a criticism; it is simply a matter of knowing full well that companies will report and highlight what makes them stand out favourably. In our weighted calculations for our ESG rating score, 45% of the inputs do not come from the company's self-reported information. Of course, we process this information as well, as one of many alternative data sources. But we also look at other data to get an objective assessment of the company's behaviour and track record.

JT: How do you think the ESG ratings landscape might evolve going forward? Will we see a concentration to a handful of players like for credit ratings? Or will we see a number of different players who essentially do different things and perhaps explore their own various niches?

RB: Today, this is still an emerging field, so you have a lot of people with aspirations in it, including potential new entrants. But in reality, in terms of the ESG ratings that are actually used by shareholders and investors, we are already in a situation where we are the leading player. I would argue that Sustainalytics is a close contender, but no one else is on a par.

From an investor perspective, the logic of using a materiality framework for ESG ratings is more established. In order to achieve the precise assessment it requires, using alternative data, significant investments are needed. This drives a need for scale and financial muscle. Just consider looking at climate change, as an example, and specifically systematic physical risk for the company or investment portfolios in real estate. To collect and analyse the data, in the case of a building you need the address to be able to inspect it. Ultimately, all the rest is models. And climate models on how to measure potential damages, etc, are relatively complicated, so you need big resources to develop them. Our view is that we will see ever greater sophistication in these analyses, which not all players will have the capacity to develop. To give a full assessment of ESG risks, which is the purpose of the rating, you need to have that breadth and depth.

There is always innovation, which is of course a good thing. So you will have players with a very specific new data set. This could be interesting and relevant. But again, it's not that easy to create something which is all encompassing in terms of the number of issues, and also with a coverage of companies that is big enough to cover both equity and fixed income.

JT: How should corporates think about ESG ratings, whether or not to obtain one, and which one to choose?

RB: Companies should think about sustainability in the context of their business models. Companies that manage long-term risks properly or better than their competitors tend to have a big focus on also capturing sustainability opportunities, either in their product range, or by being more efficient. So what matters is not necessarily to try to tick the boxes for the rating score. Sure, that looks good. But what we measure is the strategic ability to have revenue growth linked to sustainability or to manage risks better, so you ensure that you don't lose your licence to operate.

An ESG rating can help a company focus its attention on those key issues that are very relevant, and then work through a benchmarking exercise to understand who the leaders are. For a particular sector, which companies are the best-in-class players and how can you as a company get to that level? This will again make them think about product strategy, efficiency and the element of disclosure.

The end goal should be managing risk and seizing opportunities better than the competition, which goes beyond trying to optimise an ESG rating score. But the score does ultimately matter, and it is what we are trying to measure. The rating is a powerful benchmark for ESG progress, and that is often why companies subscribe to our ratings. But this is just a means to an end. The end goal is to be successful in the long run.

As for what ESG rating to choose, an easy option is to simply listen to your shareholders. How do they measure ESG performance? In reality, they mostly use MSCI and Sustainalytics ESG ratings. If you want to use another yardstick, it is up to you to argue your case for why you do.

JT: Do you see credit rating agencies becoming more deeply involved in the sustainability area to play a role there beyond what they do now? Do you think there is a scenario where sustainability could be a dimension of the credit rating or vice versa?

RB: Credit rating agencies are clearly looking at ESG issues in their credit assessments. I believe they will become more and more sophisticated at doing so, but the main focus will remain the credit rating outcome, which is more short-term and has its own logic. I think it's difficult if your credit rating agency then has to create an ESG rating which you know has the potential to cannibalise or confuse. If you want to keep your existing client satisfied, that is just always more difficult. But they are very research-driven organisations and invest quite a lot in this field, so I would expect them to explore the ESG dimension further.