5.1 Introduction to sustainability ratings: general dynamics

Given the increasing globalized world we live in, with technology developments and increasing real-time spread of information, companies are in constant strict scrutiny. Their impact in capital markets, environment and society have been recognized and therefore, full attention is paid to their every move. Companies have to manage their business and financial risks, relation with all its stakeholders, their financial, environmental, social and governance (ESG) impacts created by themselves and to others, and its own reputation. Corporate competition is increasing and this is a result of a growing understanding of the advantages of the value of ESG risks real-time data by their peers. Companies are increasingly motivated to compete for the best sustainability disclosure and performance.1 Since more than two decades ago, SustainAbility, a research provider, has observed the growing number of ratings, rankings, indices and awards that aim to measure, compare or reward corporate sustainability performance. At the time, it was anticipated that socially responsible companies, in particular the frontrunners included e.g. in a sustainability index, would outperform the laggards and therefore, become more attractive to investors. Those companies who would be able to demonstrate how well they manage their ESG risks would be included in a sustainability index or in other ESG ranking. This inclusion would bring them higher visibility, superior reputation, competitiveness, stimulate the demand for their shares, and potentially increase their price.2 Who can provide stakeholders with real-time ESG data? The ESG raters. The ESG raters have developed tools to gather, analyze, qualify and rate corporate ESG risks and disclosure of ESG information. They work to provide useful information to target audiences (e.g. investors, consumers, companies) and contribute to make better-informed investment decisions. A way to help the management boards to be aware of and anticipate the ESG risks, to increase their knowledge and add value to the decision making process, is through sustainability ratings. Sustainability ratings are “a potentially powerful but still underused tool for building a competitive, socially purposeful, and financially sound enterprise.”3 These specialized ratings provide information about the companies’ ESG risks and are still a quite underused tool amongst companies and investors.4 Companies increasingly understand the value of sustainability ratings and are increasingly using this information to the benefit of not only their risk management but also of their reputation, to identifying new market opportunities and to attract lower cost of capital.5

This chapter focuses particularly on the sustainability indices and sustainability rating agencies. It provides an introduction to the general dynamics of sustainability ratings, introduces a few lessons from the credit rating agencies and looks more thoroughly to the role of sustainability indices and sustainability rating agencies.678 Among the topics introduced are, the UN Sustainable Stock Exchanges (SSE) Initiative, the CERES Investor Listing Standards Proposal, the WFE Sustainability Guidance and Recommendations and the ratings process. It the lays a roadmap for the future of sustainability ratings, considering policy and regulation and promising future developments as green bonds, the yield companies and the potential influence of China’s ambitious environmental agenda. It follows with a look into frontrunner sustainability indices based in Brazil and the US respectively, and two renowned sustainability rating agencies, the CDP and MSCI. The chapter ends with the main challenges driving the sustainability ratings agenda.

Stock exchanges are highly regulated markets where stocks, securities, commodities, foreign exchange, futures, and options contracts are both bought and sold. Quoting the London Stock Exchange, stock exchanges are meant “to provide issuers, intermediaries and investors with attractive, efficient and well-regulated markets in which to raise capital and fulfill investment and trading requirements.” All companies listed on stock exchanges are obliged to disclose financial information about their business activities. This information is meant to provide an overview of a company’s financial performance but it says nothing about their long-term ESG risks and opportunities and long-term strategy. As discussed in previous chapters, financial information alone is not enough to make a decision about a company’s long-term sustainability, operational and financial stability.9

Stock exchanges are in a privileged position within the financial markets with the possibility to positively influence their listed companies to adopt ESG policies. They have the opportunity to advance the sustainability agenda.10 Stock exchanges play a role pushing companies to do what is already in voluntary guidelines through listing rules, implementation of national legislation and also acting as a “liaison” between the listed companies, policy makers, investors and ESG organizations (experts).1112They are powerful to driving change and may have a positive impact on how companies manage their risks.