A study by a UK group shows that public companies and their investors have different views on the importance of ESG ratings and how those ratings are used
The fear of receiving an adverse environmental, social & governance (ESG) rating has not been a significant consideration for most companies when setting their strategy and planned actions to address ESG issues, research published by the United Kingdom’s Financial Reporting Council (FRC) has found. The research also found that most investors primarily used ESG rating agencies as a source of data rather than relying on the rating itself to inform voting decisions.
Alongside its research report looking at the impact of ESG ratings agencies and proxy advisers on companies and investors, the FRC has also released a separate research report on the views and approach of corporate audit committee chairs to ESG activities and reporting.
That research found that while audit committee chairs had a keen interest and understanding of ESG activities within their company, their involvement in decision-making processes was often limited. Their primary role was concerned with risk management, compliance, and ensuring effective reporting.
In March, the U.K. government launched a consultation on proposals to bring ESG ratings inside the regulatory perimeter. Similarly, the European Commission has adopted a regulation (which is now subject to the legislative process) on the transparency and integrity of ESG rating activities.
The impact of proxy advisors and ESG ratings agencies
The FRC’s research was focused on FTSE 350 companies and asset managers and owners. After identifying “notable differences” in the use and relationships of companies and their investors with proxy advisors and ESG ratings agencies, the FRC decided to assess the influence of each separately.
Almost all investors were found to use the services of proxy advisors. Among the findings on their influence were:
- an increasing number of investors ask for voting research to be based on their own in-house policies rather than the advisor’s standard policies, and most investors issued voting instructions based on recommendations from proxy advisors without manual intervention where the resolution was uncontroversial;
- There did not appear to be many notable differences in voting behavior based on the size of the investor or the choice of proxy advisor, and except in relation to remuneration, recommendations by the largest proxy advisors to vote against resolutions were relatively rare on most topics; and
- The majority of proxy advisors and many investors do not engage face-to-face with companies during the annual general meeting or proxy season, and the majority of investors do not notify firms of their intention to vote against a resolution prior to doing so.
In relation to the influence of ESG ratings providers, it was found that most companies were concerned that investors could place reliance on headline ratings when making voting decisions and that there was a risk that companies could be penalized on the basis of a rating that, in their opinion, did not fairly reflect their actions or performance. This led to most companies proactively providing the information used by rating agencies in their methodologies due to the desire to receive a positive rating.
Also, most investors indicated they primarily used ESG rating agencies as a source of data rather than relying on the rating itself to inform their voting decisions. Some even had developed their own proprietary rating systems. However, both companies and investors would welcome greater transparency on the methodologies used by ESG rating agencies.
Finally, some concerns were expressed about the data-gathering techniques used by some ESG rating agencies and data providers (in particular, the use of data scraping and controversy reports). There were also concerns about the timeliness and timing of ESG rating agencies’ updates to their ratings and research reports which did not always align with reporting and voting cycles.
Audit committee chairs and ESG matters
The FRC’s research found that some audit committee chairs considered that, over the last two years, the environmental portion — the E in the ESG — has been prioritized over other areas. However, the importance of the social component was considered by some to be increasing, in particular in relation to board and senior management diversity, staff well-being, and equal pay.
Some audit committee chairs felt that the scope of ESG was “too broad” and continued to expand and evolve, resulting in the measurement of ESG activities becoming more difficult and inconsistent. There was also a general feeling that the increased focus on ESG in reporting was making annual reports too long, making it was more difficult for investors and the market to identify key information.