Treasury meets ESG:

ESG refers to environmental, social and governance criteria for taking sustainability aspects into account in companies. Many organizations have already incorporated these criteria into their corporate strategy. Yet the treasury department continues to play a subordinate role in aligning the company with ESG criteria. It can, however, make a significant contribution to ensuring that the company achieves its sustainability goals while simultaneously improving its financial stability. 

One way to do this is by embedding sustainability criteria in financing decisions. This could mean, for instance, that ESG criteria are factored into the selection of banking partners or financing instruments. ESG ratings are one possible tool for the treasury department to actively pursue these sustainability goals.

The emergence of ESG ratings stems from the rising importance of environmental, social and governance (ESG) factors for investors and companies. They are similar to financial ratings in that both types of ratings are used to assist investors in their investment decisions in the broadest sense. While financial ratings use corporate creditworthiness as a criterion, ESG ratings focus on a company's sustainability performance.

Beyond this purpose-driven analogy, however, it is evident that the two concepts exhibit differences in key aspects. ESG ratings cover qualitative and quantitative information on environmental, social and governance factors. The core measurement for ESG ratings – i.e., a company's sustainability performance - is a broad construct that defies unambiguous definition. This stands in stark contrast to financial ratings, where clearly defined metrics are used for evaluation. To complement financial ratings, ESG ratings have evolved significantly in recent years and emerged as an important tool for investors to factor sustainability aspects into their investment decisions.

ESG ratings are used to systematically analyze the non-financial environmental, social and governance performance of companies. However, there are different types of ESG ratings, including ESG Risk Ratings, which assess a company's exposure to sustainability risks (for example, extreme weather events), and ESG Impact Ratings, which look at the impact of corporate activities on the environment. In addition, there are other specialized ratings such as Climate Ratings.

The process of compiling ESG ratings begins with identifying and quantifying relevant ESG criteria. ESG rating agencies collect the corresponding data from sustainability reports, questionnaires and, if necessary, interview the companies to be rated. Then, this information is aggregated to facilitate comparisons between different companies in relative terms. Users of ESG ratings can then take the agencies' findings into account when making their decisions. ESG ratings are predominantly commissioned by investors with a view to reducing information asymmetries in the financial markets. The so-called investor pays model takes effect here, when the agencies are remunerated by the investors. Companies can, however, also commission an ESG rating themselves (issuer pays model), something that is increasingly being pursued by more and more companies voluntarily seeking a sustainability rating. To stay relevant, the ratings are regularly updated to reflect new findings and events.

Looking at the concept of sustainability ratings, attention inevitably turns to the providers of these ratings – the so-called ESG rating agencies. While these sustainability rating agencies date back to the 1990s, they have attracted increased attention in the recent past, particularly due to current market and environmental influences. They act as intermediaries in the capital markets, mediating between companies and their stakeholders. In recent years, the market for ESG rating agencies has seen rapid development. Multiple waves of consolidation have led to a steady decline in the number of providers, with the remaining providers significantly expanding both their market share and the range of services they offer.

Even so, a thoroughly heterogeneous field of providers has emerged, especially in comparison to the highly concentrated market of financial rating agencies: alongside major providers of financial ratings (e.g. Moody's, Standard & Poors, Fitch, Scope), which have established themselves on the market over the course of time through takeovers or specially developed ratings, there are also various up-and-coming providers of holistic or highly specialized ESG assessment products. This means that once a company has decided to apply for an ESG rating, it is faced with a large number of potential providers. Selecting the appropriate provider requires a careful analysis of the provider environment and the respective specifics.

To date, ESG rating agencies are by and large not regulated directly by specific rules or regulations regarding their activities as rating agencies for sustainability aspects. Unlike traditional financial rating agencies, for example, which are subject to oversight by regulators such as the US Securities and Exchange Commission (SEC) or the European Securities and Markets Authority (ESMA), there is no comparable specific regulatory framework for ESG rating agencies. The absence of similar rules and standards for ESG ratings and rating agencies gives providers a comparatively free hand in designing the rating process. As a closer look at the individual providers reveals, this flexibility results in significant differences in the selection, measurement and weighting of the rating components included.

At first glance, ESG ratings appear to be a useful – and in times of immense growth in the importance of sustainability aspects, almost indispensable – complement to purely financial company ratings. Still, it is important to be aware of the problems associated with the still young product of modern ESG ratings. One of the main criticisms that is regularly raised is the lack of standardization of ESG ratings. For instance, there is no standard definition for the concept of sustainability, which is the central object of the ratings. This means that each rating agency can use its own individual understanding of sustainability as a basis for its assessment, which leads to considerable differences in terms of the factors included and their assessment.

In addition, this lack of standardization causes problems with data availability and quality. Rating agencies heavily rely on information provided by companies, which, however, in many cases only disclose selective information in their sustainability reports and use their own individual calculation methods. So even though non-financial reporting capabilities have increased in scope through various regulatory initiatives, there are still considerable differences when it comes to their design and quality. These data issues affect the informative value of ESG data and thus also the rating. For instance, studies show that on average, large companies with comprehensive sustainability reports are rated better than smaller companies – regardless of their actual sustainability performance.

A further point of criticism concerns the aggregation of the key figures from the various dimensions into an overall score. For one thing, with this aggregation the weighting of the individual factors has a considerable (subjective) influence on the overall score, and for another, deficits in one category can be compensated for by positive performance in another category in this way at many rating agencies. This practice can lead to a dilution of the rating, especially in the case of holistic approaches (i.e., overarching E, S and G scores). For this reason, an in-depth understanding of the respective rating methodology is indispensable to ensure that the informative value of the selected ESG rating is in line with one's own understanding of sustainability.

But despite all the criticism, there are also opportunities ahead for the treasury department. For example, Treasury can actively shape the dialog with investors and financing partners. With transparent reporting on the company's ESG performance, investors and financing partners can make informed decisions. Treasury can help collect and prepare relevant ESG data (for example, E: energy costs; S: investment in social projects; G: transparency on financial reporting) and showcase it in an understandable way. This strengthens confidence in the company's sustainability strategy and makes it easier to access sustainability-oriented investors and financing.

An additional avenue of action for the treasury is to identify and use green financing instruments. With the increasing introduction of sustainability criteria in the financial markets, there is a wide range of green financing instruments such as green bonds, green loans or sustainable derivatives. Treasury staff can analyze these products to determine which are most suitable for the company. Embedding such instruments into a company's new product process allows it to fund its sustainability goals while reaping the financial benefits that can come with green financing. That's where ESG ratings come in, as they can be used to link financing terms to the status quo, as well as to the development of a company's own rating. 

The ESG rating can also play a positive role in the company's external image, as an assessment by an official agency contributes to the company's credibility. This projects a good reputation to all stakeholders. Similarly, ESG ratings from relevant stakeholders such as banks, customers and suppliers can be factored into financial risk management. By incorporating these ESG factors into risk assessment and management, companies can reduce potential financial risks. This results in increased transparency between all stakeholders and facilitates decision-making for business relationships.

Based on the opportunities and challenges outlined above, it becomes evident that ESG ratings are currently not a fully established product. There are still no uniform standards and significant differences exist between the rating agencies. This can make it difficult for relevant stakeholders to assess the quality of the various ratings and achieve comparability. When looking at the hoped-for potential - both in terms of financing costs and the positive reputational effect - it must therefore be recognized that the acceptance of the rating results may be diminished by the heterogeneity of the various ratings. 

It is therefore advisable to weigh up the cost/benefit ratio of the respective ESG ratings in the light of the company's individual circumstances. Once the decision to obtain an ESG rating has been made, it is crucial to compare the providers and their assessment methods using a suitable selection process. This is the only way to make sure that the chosen rating fits the organization and can be communicated to its stakeholders in a credible way.

This gives the treasury department a key role to play. At the same time, it broadens the Treasury's requirements profile: the team should have in-depth knowledge of ESG to understand the relevant criteria and incorporate them into the decision-making processes. Also, it is essential that the treasury department works closely with other corporate departments such as sustainability, investor relations and risk management to reach a well-rounded opinion. Going forward, we can expect the importance of ESG factors to continue to grow. Accordingly, now is the time for Treasury to proactively address the issue to capitalize on the opportunities that come with strong ESG performance.

Source: KPMG Corporate Treasury News, Edition 134, July 2023
Authors:
Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG
Karin Schmidt, Senior Managerin, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG