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Back in 2019, we launched our proprietary sustainability ratings, and incorporated these into our research and investment decision-making process. Third-party ratings, we felt, were often backward-looking, provided insufficient detail and didn’t suit our bottom-up approach. Having our own ratings proved to be an effective way to start thinking about how ESG risks might affect company valuations and long-term prospects.
During the Covid-19 crash, oil shock and subsequent recovery in 2020, we took a snapshot of performance which showed that companies with better ESG characteristics were likely to be more resilient. See our paper Outrunning a crisis: Sustainability and market performance.
However, the increasing emphasis on real-world outcomes has encouraged us to evolve our proprietary system so that it now embeds “double materiality” (the impact a company has on communities and the planet, and vice versa), giving our analysts deeper insights into material non-financial, as well as financial, factors.
Comprehensive and comparable
We now have 26 environmental, 14 social, and seven governance indicators, supported by 130 underlying data points alongside analysts’ qualitative analysis for each indicator. Key indicators are identified and weighted by subsector (not just sector), making their materiality far more granular and relevant. Our scoring methodology, however, remains consistent across key indicators, allowing companies to be compared on an absolute basis rather than just in relation to their peers.
We rolled out the second iteration of the framework in Q1 2022 and have since exceeded our coverage targets by rating over 3,700 issuers. Our aim is to get to c.4000 issuers across equity, sovereigns, corporate bonds, and private credit in the next few months. While the ratings will continue to evolve, the new modular approach means further data points can be added easily.
Limitations of our approach
The in-depth nature of our approach means that our coverage is not as broad as a third-party provider, therefore we continue using third-party providers in order to supplement our limited coverage. Further, the ratings framework is being used by some 200 analysts globally with varying degrees of understanding of the different ESG issues covered, which creates variability in the output. We are addressing this challenge by providing training on the ratings framework and on specific themes and sectors.
How the ratings are used
The sustainability ratings are used in a few ways. First, they are used by the analysts to capture their insights on a company’s ESG characteristics and can help inform their views on a company and if they recommend a buy, sell, hold position.
Secondly, they can also be used by portfolio managers at different stages of their investment process. It is important to note that each portfolio manager has their own approach and the way and extent to which the ratings are used depends on this approach. Thirdly, we can use them for monitoring of a fund’s ESG characteristics and the fund’s classification within regulatory frameworks like SFDR. On the stewardship front, we can use them to prioritise and guide engagement with companies. Finally, we use the ratings for client communications and reporting.
We asked one of our senior analysts, Heidi Rauber, to describe how she found the ratings process and whether it had made a difference to her analysis.
Q&A with Heidi Rauber, consumer staples analyst
How have Ratings 2.0 made a difference to you?
The second version of the ratings has allowed me to differentiate more between companies, as we now have separate numeric ratings for E, S and G, as well as an overall letter rating A to E, though typically my companies sit in A-C buckets. Having numeric scores for each allows for greater granularity and differentiation as we rate every single factor and subfactor.
My process is first to assign numeric scores to all the companies I cover across the range of factors, then rank them by the sum of the numeric scores to see if my overall letter rating makes sense. Where I find companies with the same score but a different letter, it prompts me to reflect on whether this is justified or not. I have adjusted a couple of ratings on this basis, and the overall result has been a wider distribution and fewer issuers achieving the overall highest A rating.
Where do you find the information necessary to score companies on different factors?
I typically start by analysing company publications and complement that with my existing sector knowledge. I further research areas where I have more questions and follow up with investor relations or senior executives. Then I use a range of tools to help me track corporate developments.
I also assess the targets that companies set, how stretching they are, and a firm’s track record of achieving past targets. For net zero targets, we look at the level of detail provided in a company’s plans, and how they track progress. Some companies have yet to publish net zero plans which I view negatively when it comes to scoring.
The Ratings 2.0 framework allows for greater nuance, e.g. the distinction between the percentage of energy vs electricity derived from renewable sources or where companies are not clear about their water usage or waste management along supply chains. Once we have identified areas of concern, particularly this year around biodiversity, we can push companies to improve their disclosure and share best practice. Many consumer goods firms have a “Sustainable Agriculture Code” that ensures that farmers follow sustainable practices, but the more comprehensive Ratings 2.0 framework details both the leaders and those with whom Fidelity needs to engage more intensively to drive change.
Ratings 2.0 also enables a deeper dive on social factors, so I typically assess a company’s safety procedures, code of ethics, supplier code of conduct, privacy policies and marketing policies (particularly important for alcohol, tobacco, and infant formula). I pay special attention to employee engagement scores, turnover rates, whistle-blowing policies and workplace fatalities (particularly in beverages), especially where companies claim to survey their employees on these issues but don’t publish the results or exclude parts of their workforce.
What extra insights has Ratings 2.0 given you?
The increased granularity and the ability to draw in different data points have given me a more complete picture and helped raise my confidence levels around the ratings, and their impact on valuations and investment cases. One example is that I now spend more time considering employee perceptions of the company they work for. This reflects both whether employees have truly bought into management’s agenda at a strategic level, but also whether they feel taken care of.
I have not made any rating changes on this basis, but it has confirmed my view of one company that had already been rated a Sell due to concerns around governance. Ratings 2.0 also allows me to incorporate event-driven news more quickly into my investment recommendation, especially if I’ve already identified an ESG red flag. Ratings can be reviewed at any time, but we’ll often look at them when companies issue annual ESG reports or formal updates. The information we collect helps capture ESG trajectories and provides context for future investment case reviews.
What are the benefits of an investment analyst rating companies as opposed to an ESG analyst?
The main advantage is that the discussion with management becomes much more strategic. As financial analysts, we regularly host meetings with CEOs and CFOs of companies. This allows us to judge their true commitment at the most senior levels and we see it as a red flag if they are not well versed in discussing ESG issues.
Another benefit arises from assessing board composition. Due to our sector coverage, we have often already met with new board members that are industry experts in their previous executive roles, e.g. the previous CEO of Remy joining the board of Danone. We therefore often have direct knowledge of their execution track record and key strengths and can formulate a view of their effectiveness as board members. That said, we work closely with our sustainable investing colleagues on a range of engagements, particularly where they apply across the coverage universe.
How do the sustainability ratings sit alongside financial ratings?
The ratings are done completely separately, and I do my best not to bias sustainability assessments towards my stock ratings. However, I have found that the highest quality companies have tended to be the most advanced when it comes to sustainability. I believe this is because they have greater control over their performance, freeing up time to think longer term and more strategically. There are instances where sustainability ratings have filtered through into stock ratings: for example, I recently downgraded a stock where I felt the management incentive programme was not fit for purpose. In tobacco, the commitment to transition consumers to healthier alternatives is critical, and this has influenced my preferences and stock recommendations.
What practices are you looking for in a consumer company that are good or bad ESG wise?
I don’t just look for the absence of negatives, but also for positives. For example, Nestle fortifies many products sold to lower income consumers in emerging markets with micro-nutrients, based on their mapping of the most common deficiencies. Equally, companies like Proctor & Gamble haven’t signed up to major plastics initiatives such as that organised by the Ellen MacArthur Foundation, but our engagement with Proctor & Gamble revealed credible targets on plastics.
I also look for a history of incorporating ESG principles into a company’s culture. Some companies have been highlighting ESG topics to investors for many years, especially in relation to diversity and employee welfare. I do recall times when investors used ESG presentations as “Blackberry breaks”. But most of these companies now have ESG far more ingrained in their corporate cultures than those that have adopted it more recently on the back of pressure from capital markets. They also tend to have better disclosure, not just around company activities but via transparent product labelling and sustainability awareness campaigns on topics like clothing and plastic.
And finally, I look closely at whether a company is on an improving or deteriorating trajectory in terms of its sustainability rating. This helps me understand the nature of the ESG-related risks or opportunities that are emerging and that could have a significant positive or negative financial and/or non-financial impact.
Visit our website to discover more about our ratings process and watch a walk-through.