Mary Jane McQuillen, Head of ESG Investment, and Charles Harris, Director of Research, discuss ClearBridge’s proprietary ESG ratings system.
What are ESG ratings and why were they developed?
To formally recognize Environmental, Social & Governance (ESG) factors in our investment process, ClearBridge Investments has an internal ESG ratings process across our equity research platform. ESG ratings are proprietary scores intended to signal to investment teams how well a company has executed its ESG practices. ClearBridge analysts have integrated ESG factors into their processes for generating investment recommendations for many years. ESG integration has also been formally included in the analyst performance reviews and the analyst compensation structure.
Evaluation and analysis of Corporate Governance practices, for example, are a core part of our fundamental research process and are done for every company in our coverage universe. The Social factor is equally considered as labor/hiring practices, community involvement and reputational issues inform our overall analysis of a company's attractiveness as an investment. Environmental performance is integrated to different levels, depending on the industry, with it playing a significant role for companies in highly regulated industries such as utilities.
"ESG ratings are proprietary scores intended to signal to investment teams how well a company has executed its ESG practices."
Long-term ESG policies are relatively new in the U.S. With companies early on in their adoption of ESG practices, a primary motivation in publishing ratings is to engage companies and help them establish baseline ratings against which to measure their progress and communicate their accomplishments. Given our experience and reach across industries, ClearBridge is well-positioned to technically apply the environmental, social and governance-related standards used to develop formal ratings.
What is your scale for ESG ratings?
We assign companies one of four ESG ratings, ranging from AAA (highest) to B (lowest) that is based on their own performance/behavior and a comparison with industry peers. In general, the ratings correspond to the following levels of ESG success or leadership:
AAA - Best in Class: Company has integrated ESG strategy into its business model, usually with full CEO and/or employee support; formally measures sustainability efforts and proactively communicates to investors. Often, these are companies that are providing goods and services that have a positive effect or impact on society or the relevant industry.
AA - Intermediate: Company sees value in ESG factors, has begun to incorporate sustainability into business operations and products and has started reporting its progress.
A - Beginner: Company recognizes potential to capitalize on ESG improvements.
B - Flagged: Company that has not focused on ESG, has a poor ESG record or operates in an unsustainable industry.
What research processes do you use to generate company ESG ratings?
As with our overall fundamental research process, we may analyze the ESG characteristics of companies on both a quantitative and qualitative basis. Quantitative factors are applied where industrywide data is typically available, such as carbon emissions levels in the utilities sector or employee safety data in the industrials sector. In sectors where our research has identified an industry leader in sustainable practices, labor and workplace polices or other ESG factors, analysts will often use that company as a benchmark for quantitative and/or qualitative comparison. Face-to-face meetings and engagement with companies, consultations with ESG experts as well as published research and public disclosures all factor into the formation of ESG ratings. Each analyst is afforded flexibility to define which ESG-related issues are most relevant to the companies in their specific sector and how to evaluate them.
Do ESG ratings reflect just the ESG characteristics of a company or more broadly reflect the risk/reward?
First and foremost, our proprietary research process seeks out quality companies with sound fundamentals. ESG is a critical part of the normal due diligence we perform as part of our fundamental analysis. With the ratings, we are pulling this out of the process and highlighting it with a specific, codified rating. The research and ratings process are integrated but produce two outputs: an investment recommendation and an ESG rating. Our ESG ratings are formulated independent of individual stock recommendations. However, ESG ratings do factor into an investment conclusion. An ESG rating by itself is not a recommender or disqualifier. For example, an AAA-rated company may not be considered for investment due to valuation or other factors. Conversely, a company may be B-rated from an ESG standpoint but recommended as an investment due to attractive fundamental characteristics.
How does your ratings process differ across industries?
ClearBridge has established broad guidelines for our research analysts to follow in formulating specific company ratings. Based on their experience and industry knowledge, analysts determine the industry-specific factors that drive ESG ratings and what they will consider an A-rated company versus an AAA-rated one. The factors our analysts may consider could include a history of focus on the environment, a solid disclosure track record, stated ESG goals and the progress toward those goals and if company actions have caused change in their industry. For regulated industries, environmental and state regulations carry more weight in determining ratings. For other industries, energy usage, employee engagement or product quality/safety may take precedence.
What are some examples of how you assign ESG ratings?
In the utilities sector, we use a combination of quantitative and qualitative analysis to rate our coverage universe. For utilities, we measure carbon emissions data that each company is required to disclose. Based on this quantitative screen, we eliminate companies with the worst emissions profiles. We then look at fuel mix - coal, natural gas or nuclear generation - quality of assets and the amount of power generated from renewable sources. Considering quality of assets is important because the newest coal plants might have cleaner emissions than older natural gas plants. Utilities that screen well on emissions are eliminated if nuclear power is a significant portion of their electricity generation. For the remaining utilities we then examine qualitative factors such as management vision, shareholder friendliness and corporate strategy to determine ESG ratings. A utility company may have strong management or have a solid track record of reporting/disclosure but because of its pollution profile or fuel mix, we cannot recommend it.
Within the consumer discretionary sector, qualitative factors form the basis of ratings and the importance of the E, S and G components will vary from sub-industry to sub-industry. A primary question we ask: is there a driver of the business tied to sustainability? For restaurant and food service companies, growing demand for natural organic foods, sustainably sourced ingredients and food safety priorities will weigh heavily on our analysis. For retailers, sourcing and labor practices and energy/transportation policies are important considerations.
Beyond investment, how are our ESG ratings utilized?
ESG ratings are monitored continuously by analysts and updated at least annually. They are a proprietary measure that not only informs the investment decisions of our portfolio managers but also guides how we use client capital to make an impact in the companies where we invest. Ratings communicate to portfolio managers our confidence in or expectations for progress on ESG issues and the ratings are included in all the company research notes circulated internally by the analysts. We strive for our ratings to accurately reflect the most current sustainability efforts of the stocks we cover and they provide a framework to prioritize our discussion topics during communications with these companies. ESG ratings will underpin our ongoing company and industrywide engagement to raise awareness of the importance of ESG issues and their beneficial effects on corporate performance.
What differentiates ClearBridge from other ESG managers?
At ClearBridge, ESG is not merely a screen or overlay; it is part of how we conduct fundamental research. We have been managing ESG investment portfolios for over 25 years and ESG ratings are the latest illustration of ClearBridge Investments' commitment to integrating ESG factors into our quality-focused fundamental research process. Unlike boutique firms with a narrow ESG or sustainability focus, our centralized research team provides broad global coverage across all major industries and market capitalizations. This scale, with ClearBridge often taking concentrated position weightings in companies, combined with our experience as a leader in ESG investing, enables us to drive positive change through company engagement, proxy voting and promotion of best practices.
What are some examples of companies at each ESG rating level?
Ratings Case Study: B
This global chemicals company earns a B-rating as uninvestable primarily due to the Environmental impact of the powerful pesticides it produces. Recent corporate actions, including the spin-off of ancillary businesses, have made pesticides responsible for approximately 80% of revenues. The company also rates poorly due to its outsourcing of pesticide production to Chinese chemical producers with questionable environmental practices as well as poor corporate governance in the lax lending terms it provides farmers to purchase its product.
Ratings Case Study: A
Ralph Lauren (RL), the lifestyle apparel wholesaler known for its Polo brand, operates in an industry exposed to risks from a materials sourcing and factory labor conditions standpoint. While Ralph Lauren is no more prone to these risks than its peers, the company has not communicated specific commitments to source sustainably-produced raw materials or provided transparency on its practices to prevent forced labor among vendors, which keeps its rating at an A at present. Ralph Lauren has taken positive steps in reducing its reported carbon emissions and energy usage, created a vendor approval and training process and issued two citizenship reports outlining its Social and Environmental responsibility efforts. From a Corporate Governance standpoint, the company has a dual class share structure where founder Ralph Lauren controls 81% of voting power. We would like to see the company provide more details on its commitment to fair labor practices, sustainable sourcing and its overall sustainability efforts.
Ratings Case Study: AA
NextEra Energy (NEE) is the largest wind and solar energy producer in the U.S. and is driving earnings growth from these low-carbon energy sources. The company has a strong Environmental record with one of the lowest CO2 emission rates and lowest percentage of energy generation from coal among U.S. utilities. It is also promoting consumer energy conservation through installation of 4.5 million smart meters to make the power grid more efficient and reliable. Subsidiary Florida Power & Light is investing $500 million in storm protection to ensure business continuity. NextEra's limited nuclear generating capacity is preventing the utility from earning an AAA rating.
Ratings Case Studies: AAA
Nucor (NUE) is the largest steel producer in the U.S. and the largest recycler in North America. The company is generating profits and earning industry recognition for its efficiency initiatives. Nucor maintains an industry-leading Environmental record due to steel production methods that use recycled scrap rather than iron ore and natural gas instead of coal. These methods have led to lower emissions, energy and water consumption. The company has a strong Social record that includes creating its own supply chain checks in Brazil to avoid firms using slave labor which are being adopted as an industry standard. In addition, Nucor exhibits a solid Corporate Governance structure featuring variable compensation that, combined with low-cost operations, eliminates forced layoffs during difficult economic periods.
Ecolab (ECL) is a global leader in cleaning, water and hygiene services for commercial customers. The company's core business makes a positive Social impact by providing healthy solutions to challenges in food safety, water scarcity and hospitality. Ecolab also scores well in its Environmental efforts, leading by example in its waste reduction program by setting goals of 20% reduction in water use and 10% reduction in greenhouse gas emissions from 2012 through 2017. Its 3D TRASAR technology that detects and treats deposits in cooling systems has helped customers save over 70 million gallons of water. Ecolab also helps businesses make responsible water use decisions through free distribution of its Water Risk Monetizer modeling tool. In terms of Corporate Governance, the company has a high representation of women on its board of directors relative to its U.S. peers.
Can you provide an example of a company whose rating has improved?
Panera Bread (PNRA), the U.S. fast casual restaurant chain, was a first-mover toward using higher-quality ingredients without artificial additives and has been purchasing livestock raised responsibly (without the use of antibiotics and in a reduced-stress environment). However, the company had been held back by the lack of a coordinated ESG strategy which limited its ESG rating to A. Over the last year, Panera has increased disclosure of its strategy by publishing a sustainability report that outlines its ESG policies and can be used as a baseline for quantifying its progress going forward. In 2015, Panera extended its commitment to high-quality ingredients by announcing a list of more than 150 artificial ingredients that it has eliminated or intends to remove from its menu. As part of its Panera 2.0 initiative, the company has also empowered healthier eating by allowing customization of online orders. When customers add or remove ingredients from a menu item, the website now automatically updates nutrition information.