ESG Ratings: Integrating Fundamental Analysis with Environmental, Social and Governance Considerations

Mary Jane McQuillen, Head of ESG, and Charles Harris, Director of Research, discuss ClearBridge’s proprietary ESG ratings system.

ClearBridge Investments has an internal environmental, social and governance (ESG) ratings process across our equity research platform that captures these factors in our investment process. 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 more than 30 years; we began formally incorporating ESG analysis in analyst compensation and performance reviews in 2012 and introduced our proprietary ESG ratings in 2014.

Analysis of corporate governance practices, for example, is a core part of our fundamental research process and is done for every company in our coverage universe. Social factors such as diversity, equity and inclusion (DEI), labor/hiring practices, community involvement and reputational issues also inform our overall analysis of a company’s attractiveness as an investment. Environmental performance is also an integral part of company analysis, depending on the industry.

A primary motivation for using formal ESG ratings is to provide a standardized and transparent internal metric, that is both quantitative and qualitative, to help analysts and portfolio managers measure and analyze a company’s sustainability risks and opportunities. The ESG rating also assists in benchmarking relative to industry peers. While some companies have considerable experience in understanding and adopting ESG practices, as evidenced by growing environmental and social disclosures and climate- and DEI-related commitments, other companies are early on in the process. Analysts use ESG ratings to help establish baseline company ratings against which to measure the progress of companies in adopting ESG practices (typically through company engagements) and communicate their accomplishments.

Given our experience integrating ESG and fundamental analysis and engaging with companies, as well as the breadth of our analysts’ expertise across industries, ClearBridge is well-positioned to develop formal ESG ratings that technically apply environmental, social and governance standards.

Proprietary ESG Rating System

We assign companies one of four ESG ratings, ranging from AAA (highest) to B (lowest), based on their performance/behavior and relative to industry peers. In general, the ratings correspond to the following levels of ESG success or leadership:

• AAA — Best in Class: The company has integrated ESG strategy into its business model, usually with the full support of the CEO and/or employees; 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: The company sees value in ESG factors, has begun to incorporate sustainability into business operations and products and has started reporting its progress.
• A — Early Stage: The company recognizes the potential to capitalize on ESG improvements.
• B — Flagged: The company has not focused on ESG, has a poor ESG record or operates in an unsustainable industry, with little to no disclosure.

As with our overall fundamental research process, we analyze the ESG characteristics of companies on both quantitative and qualitative bases. We apply quantitative scores to ESG factors that are considered to be the most material and relevant to each company’s industry. In some cases, industrywide data is typically available, such as carbon emissions levels in the utilities sector or employee safety data in the industrials sector; in other cases, the analyst will derive primary company research from his or her own direct analysis. In sectors where our research has identified an industry leader in sustainable practices, labor and workplace polices or other ESG factors, we will often use that company as a benchmark for quantitative and/or qualitative comparison. Face-to-face meetings and engagements with companies, consultations with ESG experts, published research and public disclosures all factor into the formation of ESG ratings.

First and foremost, our proprietary research process seeks out quality companies with sound fundamentals. We consider the integration of ESG to be a critical part of the normal due diligence we perform as part of our fundamental analysis. ESG ratings may, at the same time, highlight ESG-specific factors to be better compared and understood.

The research and ratings process produces two outputs: an investment recommendation, which includes a valuation, and an ESG rating. Although ESG ratings factor into investment recommendations, they generally are not the determinative factor; ratings by themselves are not recommendations to buy or sell a stock. 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, and will be closely monitored by the analyst.

In recent studies of performance and fundamental characteristics of ClearBridge’s ESG-rated stocks published with the United Nations’ Principles for Responsible Investment (PRI), we found that higher ESG-rated stocks outperformed the market more frequently than lower ESG-rated stocks. Higher ESG-rated stocks generated higher risk-adjusted returns (as measured by their Sharpe ratios) than lower ESG-rated stocks, with AAA and AA stocks generating higher risk-adjusted returns than the S&P 500 Equal-Weight Index. We also determined that higher ESG-rated stocks generated higher alpha than lower ESG-rated stocks after accounting for common factor exposures including market beta, size, value, momentum and quality. These studies show that ClearBridge’s ESG ratings system appears to contribute to performance and has an added benefit beyond that which could be explained by common quantitative factors and fundamental financial metrics.

ClearBridge has established broad guidelines for our research analysts to follow in formulating specific company ratings. Helped by the experience and industry knowledge of our analysts, we determine the industry-specific factors that drive ESG ratings. Factors considered may include a history of focus on the environment, a decarbonization strategy, 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.

ClearBridge uses a proprietary materiality framework that identifies the key ESG considerations for each sector and subsector under analyst coverage. The ClearBridge ESG Materiality Framework™ focuses on the ESG issues that truly matter for each company. It leverages our analysts’ many years of experience and supports and complements the research performed by portfolio analysts and portfolio managers who focus on particular strategies, often collaborating on company coverage.

ClearBridge ESG Materiality Framework™ Sample

In the utilities sector, we use a combination of quantitative and qualitative analysis to rate our coverage universe. First, we measure companies’ emission profiles per unit of power produced, looking at three different emission components: carbon dioxide (CO2), nitrogen oxide (NOx) and sulfur dioxide (SO2). On the basis of this quantitative screen, we downgrade companies with the worst emission profiles. We then look at the companies’ fuel mix (coal, natural gas, nuclear and renewables) to identify those with better generation fleets and/or with sizeable nuclear generation. For gas utilities, we compare companies on fugitive methane emissions per mile of pipeline to identify strong performers. We then examine qualitative factors such as management quality and track record, safety of operations and each state’s regulatory profile; we prefer companies operating in states with constructive regulatory regimes. Additional factors considered in our framework are workforce diversity and quality of board of directors, where we examine aspects such as female and minority representation on the board and the percentage of independent directors on the board.

Within the consumer discretionary sector, qualitative factors form the basis of ratings and the importance of the environmental, social and governance 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.

ESG ratings are a proprietary measure that not only informs the investment decisions of our portfolio managers but also guides how we use client capital to seek 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. In addition to a formal annual review, these ratings are continuously monitored by analysts and are regularly included in company research notes circulated internally.

We strive for our ratings to accurately reflect the most current sustainability efforts of the companies 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 industry-wide engagement to raise awareness of the importance of ESG issues and their beneficial effects on corporate performance.

At ClearBridge, ESG is not merely a screen or overlay; it is an integral part of how we conduct fundamental research. We have been managing ESG investment portfolios for over 30 years and ESG ratings are only one illustration of ClearBridge’s commitment to integrating ESG factors into our quality-focused fundamental research process. Unlike boutique firms with a narrow ESG or sustainability focus, our centralized sector research team provides broad global coverage across all major industries and market capitalizations. This scale, with ClearBridge portfolios often having 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.

Ratings Case Study: B

This hospital and health care services company is among the better operators of mental health facilities, but it has faced issues regarding patient rights in the past. Current concerns involve Medicare and Medicaid billing practices, as well as labor relations challenges, as the company is experiencing difficulty adequately staffing its facilities and faces strained relations with unionized workers. On the governance side, despite being publicly listed, the company’s founders retain excessive voting control. While the company is conservatively financed, has deployed capital rationally, and has generally been managed in the best long-term interest of all its shareholders, the seriousness of its social and governance red flags earn this company a B rating.

Ratings Case Study: A

Verizon (VZ), in the communication services sector, is a telecom conglomerate. From an environmental perspective, Verizon has committed to reach net-zero emissions by 2035, although that is behind some of its wireless peers. While recent initiatives around fixed wireless service have improved access of broadband to otherwise unconnected customers (helping bridge the digital divide), wireless service providers are subject to strict regulatory standards across multiple areas (accessible services for lower-income populations, health impacts, spectrum allocations), leading to some regulatory risk for Verizon. The company also handles large amounts of customer data, which has led to concerns around privacy in the past.

Ratings Case Study: AA

Bank of America (BAC), in the financials sector, is one of the world’s leading financial institutions. The company has dramatically overhauled its operations and strategy and significantly improved its technology over the past decade. Its focus on “responsible growth” includes treating customers fairly (e.g., providing credit and pricing of products) and it has had a positive effect on the company’s credit risk, as reflected in Bank of America’s consistently strong results in the Fed’s annual stress tests. It scores highly on the environmental impact of its products; the company has committed $1 trillion by 2030 to speed the transition to a low-carbon, sustainable economy. This is an increase from a $300 billion commitment in 2019. The company has also targeted net-zero GHG emissions before 2050 and is a leader in issuing green/sustainability bonds, with ~$10 billion issued since 2013. Bank of America has also been a leader in sustainability disclosures with CEO Brian Moynihan the chairman of the International Business Council, which is guiding the industry on standardizing ESG disclosures. Bank of America is committed to maintaining a diverse workforce in terms of experience, thought, style, gender identity and ethnicity. It was the first financial company to offer comprehensive partner benefits in the U.S. and the first to incorporate sexual orientation in its non-discrimination policies. Its programs for women have been recognized by Seramount (formerly known as Working Mother Media) for 30 years. All these strengths speak to the quality and integrity of management at Bank of America. At the same time, we acknowledge there are risks that attend this large, complex and highly regulated company.

Ratings Case Study: AAA

McCormick (MKC), in the consumer staples sector, is a leader in the seasoning and spice industry. McCormick has aggressive targets for GHG, water usage and waste reduction, with the goal of 100% sustainable sourcing. The company is working to reduce bottle packaging weight while increasing the amount of recycled material in its packaging. It maintains strong relationships with farmers, with whom it works to educate on sustainable agricultural practices and provide opportunities for women in farming communities; for its organic spice line, it seeded an entire organic supply chain, which was a multiyear process. McCormick’s products are healthy substitutes for sugar and salt, and support eating at home, typically healthier than away-from-home eating. Governance is above average, with above-average representation of women and average representation of underrepresented minorities. While the lack of an ROIC metric in executive compensation has been a topic of engagement, compensation practices are generally strong. While McCormick has dual share classes and most shares are non-voting, all shares get a vote for change of control questions.

Johnson & Johnson (JNJ), a diversified health care company, brings important medical products to market. Social factors such as addressing unmet medical needs and health care affordability and access have been the largest weights in determining Johnson & Johnson’s ESG rating. While we continue to have concerns about corporate governance practices, among them poor executive accountability and a mixed record on allocating capital, improvements in social factors have resulted in an upgrade in the company’s ESG rating at ClearBridge from A to AA. In particular, Johnson & Johnson developed a COVID-19 vaccine which it made available on a not-for-profit basis for emergency pandemic use. An improvement in the company’s compensation practices, specifically removing one-time gains from consideration in bonus plans, also contributed to a rating upgrade.