There are strong business reasons for corporates to engage with ESG ratings, with many stakeholders placing sustainability high on the agenda. That's according to Bob Mann, President and COO of Sustainalytics, a leading provider of ESG research, ratings and data. In this interview from Nordea On Your Mind, he talks to Nordea's Johan Trocmé about Sustainalytics' business model, the growing demand for ESG ratings and why companies need to prepare for the ESG dialogues that will inevitably come, if they haven't already.
JT: How would you briefly describe the origins of Sustainalytics, and the journey to what the business has become today?
BM: Sustainalytics has its roots in DSR, Dutch Sustainability Research, which was the research team of Triodos Bank, a Dutch niche player and pioneer in sustainable ﬁnance. They spun out the team because it was difficult to make the economics of the ESG research work at the time. A couple of Dutch institutional asset owners were early investors and clients of DSR. In 2009, DSR merged with Jantzi Research, a Canadian company founded and led by Michael Jantzi, who is Sustainalytics' CEO today. From that point, we continued to expand our global footprint, and opened offices in the US, Australia and Asia. In 2020, Sustainalytics was acquired by Morningstar.
One deﬁning characteristic is that we have historically been European, with our domicile in the Netherlands. However, while a majority of our workforce is European, most of our management team is based in Toronto, Canada. The ESG research and ratings space has always been our core. We primarily serve the institutional investor market, with most of our clients historically being asset owners and asset managers. Yet over the last three to four years, we have started to service corporations as well, driven by the introduction of SPOs (second-party opinions) on green bonds. That business has signiﬁcantly accelerated for us, and today we are the largest global provider of second-party opinions on green bonds. Given the success of our second-party opinion services, we began to offer corporates licenses to our ESG ratings. We have seen strong demand from corporates to leverage their ESG ratings for commercial purposes, such as for ESG-linked loans or bonds.
So with our origins in Europe, serving institutional investors, we are now entering the retail wealth management space and the corporate world. What has really changed is the amount of use cases that our ESG research supports. Back in the beginning, the core use case was essentially limited to long-only equity portfolios with active management mandates. Since then, the uses cases for our ESG research have expanded dramatically to include structured investment products, index construction, corporate ESG ratings, and many others.
JT: How does your business model work, and which are the most important services in your offering?
BM: At the highest level, our business can be divided into services for corporations and for investors, with about three-quarters for investors. Of our investor clients, the majority are asset managers and a minority are asset owners. Our historical audience has mainly been portfolio managers, who had a strong use case for our comprehensive coverage universe of ESG ratings. Our ESG Risk Ratings, which is our core product, spans more than 13,000 companies.
In addition to our ESG Risk Ratings, we provide a variety of compliance screening services. There are a lot of investment portfolio mandates in Europe which include strict compliance requirements, so we offer a full set of services to help investors fulﬁll those obligations. An emerging area of support is the EU Action Plan, and we help our clients to navigate that regulatory regime. We are building up the research and the information required to support the Action Plan. This new regulatory framework gives us a sound bedrock to start talking about impact authentically for the ﬁrst time. It is driving rules and disclosure that enable reasonable impact reporting, and impact is fast becoming an important theme for investors. It might seem strange for an ESG company to say this, but over the last three years the interest in impact has accelerated a lot quicker than we anticipated. On the corporate side, our business splits roughly 60-40 into second-party opinions and complementary services around them, as well as ESG risk Rating licenses for other use cases.
JT: On the ratings side, does your business work in the same way as it does for credit ratings? Do investors need to subscribe to access the ratings?
BM: My understanding of the credit business model is that the majority of revenues come from the issuer of the debt paying to obtain the rating, and the recurring payments for the rating. Until two or three years ago, our ESG ratings were entirely paid for by our investor clients. Investors subscribe to our entire ratings universe on an annual basis. This has now been complemented on the corporate side where we currently have some 500 corporates licensing their ESG ratings. So our business model has moved closer to that of the credit rating agencies in recent years.
JT: Would you say generally that interest in ESG ratings and the demand today is driven more by the investor side or the issuer side? Or are they equally important?
BM: Demand for ESG ratings today is still predominantly driven by the investor side. There are increasing use cases across the investment decision-making process, for example in reporting and compliance. And while this has led to continued growth for ESG ratings, there are now different geographical demand drivers developing. In Europe, demand is boosted by the EU Action Plan and other regulations. North America has become highly active and there is now rapid growth in the US, with new requests from mid-market asset managers where ESG is gaining signiﬁcant traction. Asia continues to lag but it is not far behind.
There is robust demand from the investor market, which I expect to continue to drive the ESG space. Corporate interest in ESG ratings has trailed behind the investor side but is now rising rapidly. Three or four years ago, maybe 20% of the corporates we rated would respond to a request for additional information or engagement. That has doubled to more than 40%. Companies have become far more proactive in helping ratings providers better understand their ESG policies and programmes.
I have been in the business for a long time and I try to avoid using hyperbole such as 'the hockey stick' or 'the tipping point'. They are used too much, yet it is hard not to do so. There is now a simultaneous general change in consumer views as well as in consumer sentiment in the retail wealth market, with signiﬁcant inflows into ESG funds. And ESG funds have generally performed well. We can remove some of the friction that can occur when integrating ESG into the fund. You have regulatory support in many jurisdictions, which is a strong driver. Climate change is the dominant issue that has raised ESG concerns, although over the past year social issues have gained signiﬁcant traction because of the pandemic and the social justice movement. Given the ESG research and ratings market has been growing north of 20% each year, I don’t see ESG being a fad. Our growth is also in line with this trajectory, and I wholeheartedly believe ESG is here to stay.
JT: How would you describe demand in the big regions, comparing for example North America and Europe vs Asia?
BM: I think there is a sophistication and a robustness of approach in Europe that underpins the demand, across asset classes and market segments, among institutions. ESG is deeply embedded in the European market, so there is broad support for it.
In the US, demand is accelerating from institutional players. Their interest has been building gradually over the past 10-15 years, and they are coming on board quickly at the same time as the retail market is starting to embrace ESG. The dynamism of the US market should not be underestimated. Their ability to progress and adjust is phenomenal. It is a surprise to see how quickly they pivot, all the way from retail to wealth to institutional investors. Retail wealth in the US is focusing on impact, while the institutions are concentrating on ESG integration and risk management. They are moving together but with different core interests. Asia is lagging; there is not the same demand or market penetration. In Asia we see a more robust market for SPOs and ﬁnancial instruments linked to ESG products. Asian companies are engaging with ESG more quickly and deeply than Asian institutional investors.
JT: Looking at your ESG ratings, how would you compare those with other ESG service providers, and how would you describe your approach?
BM: In the early days, ESG ratings were often used for multiple purposes. Our clients had different needs. Some investors would be more impact-oriented, while other investors would focus more on managing risk. Our old ESG ratings, which we retired a few years ago, took a balanced score card approach that an investor could use for various purposes. It enabled both types of users to get a reasonable outcome, even though it might not have been ideal for either of them.
While there is a lot of overlap between impact and risk, there are major differences too. We view them as different issues to be diagnosed using separate tools. So, we built an ESG Risk Rating that aims to target the material ﬁnancial risks that can be caused by ESG issues. We are developing impact-related products that cover the impact of investment decisions. We view them as separate.
Both MSCI and Sustainalytics provide separate products for risk and impact. Other providers offer a more combined approach. Our products and services are probably most comparable to those of MSCI.
I would argue that, in reality, there are not so many ESG service providers. When it comes down to competitive processes and our products are compared to those of other vendors, there is a choice of three or four providers. And 80-90% of the time the choice is between us or MSCI. I believe this will change, however, owing to consolidation. S&P and Moody's are both moving into ESG via acquisitions. There is consolidation among ESG service providers, and the large players will likely control the space in the long run.
JT: How do you think the ESG ratings landscape will evolve? A concentration to a handful of players with a similar standardised approach (like for credit ratings), or many players in different niches?
BM: I think one of the current big four players will be the ESG service provider for clients. Thematic analysis or something more speciﬁc is not sufficient. The barriers to entry for ESG ratings are high. The regulatory regime can in some cases be a hurdle for entry, just as with credit ratings. But with all the large ESG service providers bringing their capabilities in-house, those barriers become higher since they can invest to grow. So I think it is difficult for a new service provider with signiﬁcant capabilities to enter this space.
JT: Do you think the various approaches to ESG ratings will be harmonised? Do you think the credit rating agencies have a role to play in the space beyond where they are today?
BM: While more harmonisation is possible, we are not likely to have the same level of alignment as credit ratings, where the assessments of the big players are more than 90% correlated. I doubt that ESG ratings could get to more than perhaps 75% correlation between the providers. The credit rating agencies use a narrow measurement. With various ESG deﬁnitions and the wide range of pertinent issues, plus the diversity of use cases for the ratings, they will by nature be less speciﬁc. They won't be as tightly correlated.
ESG issues are relevant to making a credit rating assessment. I think the question is whether there is a role for a specialised ESG rating. Or should the focus be on integrating ESG dimensions into other assessments? Certainly there is no easing in client demand for a speciﬁc ESG assessment. As long as that is the case, I don't think credit rating agencies will dominate the space. They provide a unique assessment and tool, for a single and different purpose. They are meaningfully integrating these considerations, particularly climate change, and recognise that these issues can have a signiﬁcant impact. I think we both have a role to play, but we don’t serve the same markets and we do not have the same products and services.
JT: How do you think large corporates should think about ESG ratings? In terms of how the landscape is, who the different providers are and the different services?
BM: I ﬁnd it hard to have sympathy for ESG 'survey fatigue' among corporates. I think they should decide what is meaningful to them: who they are trying to do this for, what the reason is, what beneﬁt they are trying to derive from doing it. In turn they can look at the landscape and engage with the rating agencies for support. If they are interested and believe that investors care about these issues, they should engage with the ESG rating providers to understand how they are perceived and more effectively communicate on their policies and programs.
There are strong business reasons for corporations to embrace ESG, from supply chain to understanding the expectations and yardsticks of investors, creditors and shareholders. Many stakeholders have a strong interest in these issues.
Sustainalytics offers corporations a strong tool to have a fruitful engagement with their investors on ESG issues. Interacting with us helps them to be better prepared for those discussions. These conversations will happen if they have not happened already. It is a matter of when, not if.
JT: What are typical hurdles to corporates obtaining an ESG rating? Is it the effort involved, the cost, the transparency required?
BM: From the outside, it is not clear what the hurdle could be. The main obstacles are effort and costs. ESG is so broad that typically there is not one single department that has access to all the required information. For a typical large corporation, eight to ten different areas need to work in concert for ESG reporting. The information channels need to be created. Historically, information systems were not built for that purpose. They need to go to the human resources department for the social issues, such as health and safety. They also need to review client practices. Coordinating this information within a corporate environment can be tricky.
It is not so much that they don’t collect this information – most of it they have already. I sympathise with them since most corporate systems were not built to collate this information in a coherent way. In this context, it can be difficult for companies to respond and outsiders may not be aware of the obstacles.