The main drivers of successful ESG integration across singular asset classes
Several French large Asset managers recently committed to systematic ESG integration across all assets, a series of declarations likely to widely onboard financial markets within a whole new way of approaching investment decisions.
But while ESG has become a common factor around large listed companies and sovereign bonds, these 100% objectives are about to face some significant challenges in more complex asset classes such as small and mid-size capitalisations or private debt.
Small is bad
Asset managers complain about the strong correlation between ESG performance and company size. This bias can be observed across the majority of research providers. Stock-pickers who target a wide range of capitalisations are struggling because ESG integration means losing the opportunity of investing in smaller companies.
Or is it?
On average, SMEs seem perhaps less prepared for emerging ESG issues. Their management systems on the environment or health and safety are often less sophisticated. Their ability to monitor and report complex KPIs is limited. As a matter of fact, SMEs do not have the resources to publish hundreds of pages of hefty Corporate Social Responsibility (CSR) literature every year, even when they are listed.
Meanwhile, the actual risks associated with the company’s CSR behavior could also be significantly lower compared with a multinational corporation. For instance, each regulatory framework behind environmental or social issues only applies at a given size threshold. In France, the obligation of running an energy audit starts at 250 employees, a carbon assessment starts at 500 employees1. Regarding social factors in the supply chain, the due diligence law only applies for companies with over 5,000 employees2. Beyond legal exposure, the actual scrutiny by external stakeholders, such as regulators or NGOs, is massively lower for an SME, while the media headlines are massively dominated by the usual multinational giants.
Questioning the questions
Because exposure to ESG issues is specific, because risks are specific, because the company’s ability to act or report is specific, the assessment methodology should be carefully suited to SMEs. For example, asking a SME whether a diversity officer is in place while half of them don’t even have someone dedicated to human resources yet will appear disconnected from their actual capacities.
After more than 10 years of research dedicated to specific asset classes, EthiFinance estimates that a typical reasonable framework for a listed SMID of around 5,000 employees involves around 150 criteria, while the corresponding framework for a non-listed SME involves around 50 criteria. While EthiFinance analysts are hungry for more information, they are extremely careful not to discourage the company in answering. Each year, during the methodology review, the addition of new criteria is questioned considering companies’ ability to actually aggregate the information. Given the sensitivity of the success factors of the ESG assessment exercise, all these changes are discussed with a committee of specialists, including SME CEOs and trade associations.
Cherish company dialogue
Once the methodological framework is right, the backbone of a successful ESG assessment is the availability of highquality information on the companies under review. As there is little or no information publicly available on SMEs, the ESG analyst will need to create the conditions for intensive dialogue with the company being assessed.
Collect public information before you start
Complaining about a lack of disclosure and not spending time valuing the information that the company makes publicly available is likely to create intense frustration. It will undermine the analyst’s chances of gathering any additional information through the dialogue process. Analysts should review public documents and any internal ESG documents previously shared by the company, seeking to complete the questionnaire as much as possible and minimising the time and effort demanded from the company.
Be available to help the company answer
The contact point within the SME is hardly ever a CSR specialist. Depending on the organisation, he or she might be part of human resources, communications, a CFO, a quality officer or any person actually promoting CSR initiatives within the company. The direct consequence is that this contact point is unlikely to master a wide variety of CSR topics. For instance, the human resources officer will be totally at ease when we gather information on accident frequency rates, but might need support regarding CO2 emission parameters. The availability of ESG analysts to assist the company during the process, to explain how to feed the framework but also to clarify what investor expectations are, represents a strong driver in the gathering of high-quality data.
Deliver operating results to the company under assessment
At the end of the day, the SME will want to know what the practical implications of its reporting efforts are. If the company benefits for free from its results, benchmark elements, the possibility to communicate internally and externally on its performance, the incentive to participate actively will be higher. Delivering these results to the company under assessment for free will massively increase the quality of data for the investor. A challenge that can be met, but it requires very tight conditions for a successful ESG integration process on an SME portfolio.
PIERRE-YVES LE STRADIC
Pierre-Yves has been working in ESG analysis for 10 years. He spent several years working for Vigeoeiris, one of the leading ESG rating agencies, as Head of innovation, promoting the development of emerging ESG research and SRI products. He currently leads the EthiFinance research team providing responsible investment advisory services and ESG research to asset managers and asset owners. He is also the Director of Gaïa Rating, the leading European ESG rating agency on Mid Cap & Small Cap stocks.
1) French Energy Code. Act 2013-61. 2013 July 16. (2) French Parliament law. 2017 February 21.