Traditionally the reserve of larger firms, ESG ratings for small & mid-caps are vital – and now accessible

Sep 24, 2020
Advice for smaller companies on meeting their ESG goals

ESG scrutiny from fund managers and retail investors has risen exponentially over the past few years, a trend only accelerated by the Covid-19 crisis. Furthermore, an inter-generational wealth transfer is underway. Over the next 30 years, £5.5 tn ($7 tn) in assets will shift from baby boomers to the millennial and Gen Z demographics who are increasingly calling for companies to demonstrate the positive impact they have on wider society.  

In 2019 this was visibly demonstrated with ESG-focused funds taking in close to $70 bn, compared with traditional equity funds – weighed down with what many consider stranded assets in over-carbon-reliant industries – seeing a net outflow of $200 bn over the same period. 

The Covid-19 pandemic has only served to widen this gap as capital is readjusted toward long-term-focused ESG-compliant indexes, so it is easy to see why companies across different sectors are pouring resources into improving their credentials and measuring them against the plethora of available ESG indexes.  

Broadly speaking, this has mitigated Covid-19 risk as it insulates firms from investor flight. Indeed, the outperformance of the MSCI ESG Index, which contains higher-scoring firms from a measurement of 1,000 data points and 37 key issues yearly, is evidence of this, having outperformed the MSCI Global Index year to date.

Therein lies the problem for small and mid-cap companies. As the global readjustment of portfolios (including those focused on long-term passive strategies) begins to shift in the direction of ESG compliance, smaller firms are struggling to demonstrate their credentials at securing continued investment in this changing environment – even if ESG factors are central to their own internal structures. They don’t typically have thousands of data points, neither do they typically possess the resources to quantify the exact impact pertaining to each factor of their supply chains.

The Quoted Companies Alliance’s (QCA) Corporate Governance Code for AIM and small private listed companies, in effect since 2013, helps address this to some extent. With 10 principles, it can be used as a rough guideline for companies to make sure they are making positive steps toward ESG goals. 

But a recent finnCap survey of small-cap fund managers shows the majority would use ESG factors to make portfolio decisions (compared with a minority just three years ago), clearly indicating that a more numerically compliant, unambiguous and sophisticated system is required to help fund managers execute ESG decisions in the same way they would look at the MSCI, FTSE Russell, S&P or Sustainalytics ratings for larger-cap firms.

The ESG scorecard from finnCap can help companies do exactly this, and early results from the 102 companies that have already been ranked shows where firms from various industries can look to improve. The scorecard comprises 15 elements, easily measurable and scalable regardless of company size. They are:

1. Energy intensity 
2. CO2 intensity 
3. Water intensity 
4. Waste intensity 
5. Presence of an environmental or sustainability policy  

6. Employee turnover rate 
7. Percentage of profits paid in taxes 
8. Presence of a discrimination policy 
9. Presence of a community outreach policy 
10. Presence of an ethics policy 

11. Percentage of women on the board 
12. Percentage of independent directors on the board 
13. CEO pay as multiple of UK median pay
14. Is CEO and chairman role split? 
15. Adherence to a relevant corporate governance code (such as that of the QCA).

In order for companies to score highly, all three ESG areas must be addressed. Given the scorecard’s equal weighting, it is also important that companies look at all aspects of their output when seeking to improve their score, as ratings are weakened if one element lags behind others. 

Findings from our report indicate that different sectors fare better or worse in different categories. Take, for example, the consumer industry: while these companies score well with governance (coming first ahead of tech, industrials, support services, financials, life sciences and energy) they fall to third on social factors. 

While some factors can be explained by the nature of the industry – for example, employee turnover will inevitably be higher in a casual consumer-facing role set against a highly specialized life sciences role – there is room for improvement in other areas, such as community outreach policy, which is in place at just 50 percent of consumer firms. 

Similarly, the support services industry, which scores well in areas surrounding the environmental and social aspects, has its score lowered, on average, by a lagging governance score. Less than half of the sector’s board directors are independent and the proportion of female directors on boards is only 14 percent.

Looking into these elements and adjusting accordingly will be vital in the coming years, as demonstrated through not only the sea change toward greater overall ESG scrutiny, but also the way in which this scrutiny is conducted. Feedback from the surveyed fund managers shows that typically, just the governance element of ESG has been the center of focus. With a more climate-conscious and socially aware investor base, however, the E and S elements are set to catch up in the near future.

Companies should dissect, then, all aspects of E, S and G to make sure they deliver in each section rather than merely one their industry necessitates focus on. That’s because the coming years and points of measurement will look to make sure all elements are encompassed. 

Raymond Greaves is head of research at finnCap

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