Interview Strategic Head of ISS ESG rating agency

EMG recently had an insightful conversation with Dr. Maximilian Horster, Strategic Head of ISS ESG, one of the world’s leading rating agencies for Environmental, Social, and Governance (ESG) performance, featured below.

The development of ESG Ratings to serve faith-based investors, received a significant impetus in Europe 30 years ago with the founding of Oekom Research AG, a Germany-based business acquired by ISS in 2018. This was originally set-up to support faith-based investors, at that time predominantly from Christian backgrounds, who were developing impact-oriented sustainable investment strategies, in alignment with their values.

Now, in 2023, ESG has truly become a global phenomenon, and many of the investors it serves are from a broad range of faith-based backgrounds. There’s no one-size-fits-all approach, and as ESG extends its reach across the world, we encounter diverse answers to the same questions. This diversity is what I find particularly intriguing.

Please tell us more about your role as one of the prominent ESG data and service providers, notably the sole global entity with European ownership, and your extensive array of activities encompassing corporate ratings, scoring, engagement, and even voting.

ISS ESGWithin ISS, we boast a global team of around 650 experts spread across the world. We maintain a robust presence in Europe, North America, and the APAC region. Our value proposition is truly twofold.

First and foremost, our global reach sets us apart. While the ESG data service landscape was once dominated by European players, the majority have now migrated to North America. ISS ESG stands as a unique entity, primarily owned by Deutsche Börse in Frankfurt. This positions us in proximity to European regulations, which are pivotal in shaping the ESG landscape. Second, ESG is our sole focus. This specialization enables us to delve deeply into the various facets of ESG, emphasizing quality across the spectrum of ESG topics.

Our clients don’t merely employ our services for portfolio screening and investment decisions. They also harness our collective engagement offerings, all while aligning with diverse reporting initiatives across the globe.

It’s not uncommon for ESG ratings to be conflated with credit ratings, but there exist distinct differences. One notable distinction lies in the payment structure. Credit ratings are typically commissioned and paid for by the issuer, whereas with ESG ratings, it’s the investor who foots the bill. We assess companies regardless of their preference, ensuring complete independence and obviating any potential conflict of interest.

Credit ratings typically address the question, “Can the company pay me back or not?” In contrast, ESG ratings aim to tackle a multitude of questions. These inquiries may yield different answers when considered by various data service providers. Investors, too, appreciate this divergence of approaches, as certain topics, like climate or diversity, may hold greater significance for some. The ability to choose aligns with investors’ preferences.

For corporations, it can sometimes be perplexing to observe variations in their ratings across different providers. However, this divergence is by design and not happenstance. It arises from the diverse lenses through which companies are evaluated.

How does the ISS ESG Fund Rating assist investors in their assessment of the ESG performance of global equity and bond funds?

The ISS ESG Fund Rating serves as a swift and efficient method for evaluating funds and ETFs. Investors can easily input the fund’s identifier or search by name to access its star rating, ranging from 1 to 5, providing insights into the fund’s ESG performance. Crucially, this star rating is always contextualized within its peer group. Consequently, an emerging market debt fund is evaluated differently from, say, a Dutch equity fund.

In addition to the star rating, we offer a prime rating, which derives from assessments of the underlying companies, assets, or government bonds within the fund’s portfolio. This prime rating delves into various facets, including the ratings of underlying companies, governmental ratings, their alignment with Sustainable Development Goals (SDGs), their climate performance, and their governance practices, among others. When a fund receives a prime rating, it signifies that, from our perspective, it stands at the forefront of ESG excellence. This rating reflects that the majority of the fund’s holdings are themselves prime-rated, with minimal exposure to controversial developments.

One of the key advantages of a prime rating lies in its ability to aid investors in their fund allocation decisions, whether it involves global equities or Dutch bonds. It enables investors to discern between funds that offer exceptional ESG investment opportunities, allowing for a more informed and deliberate allocation process.

Is there a specific profile for companies located in regions such as EMEA, Central Asia, and APAC that typically utilize your services?

The utilization of ESG data is currently strongly influenced by regulatory requirements in different markets, and our services cater to all these diverse markets, irrespective of their location. For instance, if you’re a Malaysian fund provider seeking to offer a fund in Europe, compliance with European disclosure regulations becomes essential. Hence, it’s not solely the country where the fund originates that determines its suitability for our services; rather, it’s the alignment with transparency requirements, especially in the markets where the fund is available for sale.

From a reporting perspective, we are versatile and adaptable, recognizing that each region has its distinct cultural background and specific requirements. However, our overarching aim is to maintain as much universality as possible by anchoring our corporate ratings in internationally recognized approaches. For instance, the Paris Agreement has been ratified by almost every country globally, resulting in a notable convergence in our corporate ratings in this regard. Similarly, issues such as child labour transcend national boundaries and are not country-specific.

In fact, we offer an online tool for custom ratings, allowing clients to construct their own rating framework that reflects their unique approach and values, rather than adhering strictly to our predefined ratings. This feature enables clients to select specific indicators, tailoring their ratings to align more closely with their organizational ethos. It provides the flexibility to place greater emphasis on certain aspects, such as climate considerations, while perhaps assigning less weight to diversity, or vice versa.

I often draw an analogy to a barista: if I walk into a coffee shop and request the “best cappuccino in the world,” the barista will prepare the cappuccino she personally prefers, not necessarily the one I would prefer. I might prefer it with more milk and less coffee, or with a milder taste. This analogy encapsulates the dynamic nature of the ESG rating landscape, where individual preferences and priorities play a significant role in shaping the evaluation process.

How do you perceive the impact and benefits of ESG ratings, and what, in your view, constitutes an effective ESG rating methodology?

It’s important to initially distinguish between the various ways ESG ratings are utilized, as they generally fall into two underlying approaches: the risk governance approach and the impact-driven approach.

In the risk governance approach, investors seek insights into global developments that could impact financial returns. They inquire about how the world’s dynamics may either benefit or hinder their investments. Conversely, the impact-driven approach shifts the focus to understanding how investments contribute to or detract from the betterment of the world. Depending on where an investor stands on this spectrum, they may lean more towards one approach or the other. Nevertheless, both approaches employ ESG data as a crucial tool for measuring and assessing risk.

What’s intriguing is that these two distinct questions often yield vastly different answers. For instance, consider an investment in a solar panel producer situated on the shores of Florida. From an impact perspective, the investment is appealing because it contributes to greening the energy grid. However, from a risk standpoint, concerns may arise due to the increased vulnerability of the factory to frequent hurricanes, which could disrupt its operations.

Notably, the regulatory landscape plays a pivotal role in shaping these perspectives. In North America, for example, the prevailing regulatory focus is predominantly risk-centric. U.S. regulators emphasize that American investors should comprehend the risks, particularly related to climate change.

Conversely, for impact-based or faith-based investors, the criteria differ significantly. They are driven by a broader mission and may allocate funds towards specific social or environmental goals, such as combating hunger in Africa. In this context, aligning investments with their mission becomes paramount. These investors may employ different indicators and seek out ESG ratings more tailored to their impact-driven approach. These ratings shed light on whether investments have a positive or negative influence on specific societal aspects. European regulations, in alignment with this perspective, mandate that investors contribute to achieving societal goals.

In essence, the effectiveness of an ESG rating methodology hinges on its alignment with the investor’s core approach, whether it’s risk-focused or impact-driven. The methodology should serve as a reliable and adaptable tool that assists investors in achieving their unique objectives within the evolving landscape of ESG considerations.

Many of the world’s largest companies have embraced ESG reporting, but there are still many others that have not taken that step. Are there specific industries that stand out as leaders or laggards in ESG reporting, and if so, what are the contributing factors? How are the current geopolitical challenges potentially impacting the adoption of ESG reporting, and what measures can be taken to keep ESG reporting at the forefront of corporate priorities?

There’s a certain inclination toward larger companies when it comes to corporate ESG reporting. These larger entities often find themselves under a more intense spotlight and typically possess the resources to facilitate comprehensive reporting. Additionally, sectors that are prominently in focus, such as utilities or oil and gas, tend to exhibit greater transparency in their reporting practices. In contrast, companies in sectors that receive less public attention, such as advertising or bakeries, may not prioritize ESG reporting to the same degree.

Over recent years, we have observed a degree of stagnation in certain aspects of reporting. Many companies that were already engaged in ESG reporting have undoubtedly improved their practices. However, the influx of new companies entering the arena has seen relatively slow growth. However, this landscape is presently undergoing change. I’ve recently received updated figures on companies reporting greenhouse gas (GHG) emissions, and while there was very moderate growth in the past three years, we’re now witnessing a 35% increase. This trend aligns with the broader market dynamics – regulatory movements, heightened scrutiny from civil society, and a growing number of companies incorporating sustainability into their business models and product offerings.

Geopolitical challenges are a fascinating dimension of this conversation. Surprisingly, these challenges are not acting as headwinds but rather tailwinds for ESG. Why? In times of an energy crisis, investors keenly examine the energy mix of utilities and rely on our energy and extractives data to discern which companies in their portfolios are better positioned to weather an energy crisis. Take the war in Ukraine as another example. Investors utilize our sanction data to identify which companies fall under sanctions with a simple button press. Furthermore, they leverage our reference screens to ascertain companies’ involvement in weapon systems, encompassing not just arms manufacturing but also the production of technology used in weaponry. This level of analysis delves deep into the value chain.

ESG serves as an invaluable tool for investors to navigate this complex landscape effectively, compelling companies to provide clear and comprehensive information on these matters. Consequently, investors are exerting increasing pressure on companies to enhance their transparency and disclosure efforts, ensuring they have the requisite data to make informed investment decisions in this multifaceted environment.

Where do you often find funds ‘losing points’ in terms of their ESG ratings? Are there specific areas that present ‘quick wins’ for improvement but are frequently overlooked, as well as criteria that prove to be especially challenging to meet? What guidance would you offer to funds aiming for a strong ESG rating?

The primary driver of an overall fund rating is typically the corporate rating – essentially, how the underlying companies within the fund are rated in our system. To excel in the ratings, funds generally need to maintain a high bar on these corporate ratings. Avoiding poorly rated companies within your fund portfolio can significantly boost your star rating. Additionally, the peer group within which a fund operates matters. For instance, if you’re investing in European equities, the bar is set higher compared to investing in emerging markets, as the standards vary by peer group.

For corporations, two key factors come into play: transparency and performance. Achieving a ‘quick win’ often revolves around transparency. Our analysts can quickly discern the level of transparency in your reporting, and honest and accurate disclosure is essential. Our analysts are specialists in their fields, well-versed in understanding where companies stand, their competitive landscapes, and more. Overstating achievements can be counterproductive; instead, present a factual and transparent picture.

Performance presents a more substantial challenge. You must deliver on the commitments you’ve outlined. If you achieve this, our rating will reflect it positively. Your rating, in turn, can make your fund more appealing to ESG-focused investors and fund managers tasked with investment decisions.

Regarding cultural differences, yes, they are noticeable in various markets, where companies exhibit differing levels of transparency and performance. However, it’s worth noting that this gap is narrowing, particularly when companies are part of a supply chain involving entities under the spotlight. This increased scrutiny tends to drive greater transparency down the chain. Many early adopters have recognized the benefits of enhanced transparency, differentiating themselves from competitors.

In the context of our fund ratings, some companies might find themselves in a peer group that consists of funds investing in similar markets, taking such differences into account. Fund peer groups are typically defined by fund data providers. When it comes to analyzing companies, we group them together based on sector classifications, such as GICS, ICB, or other sector-specific categorizations. However, we may also classify companies differently when their ESG profiles warrant such distinctions.

Interestingly, anyone can access top-level ratings for companies and funds on our website, . It provides valuable insights into the ratings. For a more detailed understanding of the rationale behind the ratings, a deeper dive is necessary.

Looking at ‘the proportion of top-rated ESG funds by market’ (ISS website), the uptake of ESG appears not to follow the same trajectory everywhere in the world. What do you see as the main reasons why ESG is not seeing the same uptake worldwide?

In general, a substantial tailwind for ESG currently comes from regulatory actions. If you visit the PRI website, you’ll find a valuable tool that outlines all the relevant regulations. It’s worth noting that these regulations aren’t limited to continental Europe; they have a global reach. For instance, there are investor-focused ESG regulations even in countries like Kazakhstan. These regulatory interventions play a crucial role in fostering broader ESG integration across financial markets.

Another significant driver of increased ESG focus is civil society and the level of activism it exhibits. This is particularly evident in continental Europe, where there is a pronounced emphasis on addressing climate-related issues. This emphasis is closely linked to concerns for future generations and the preservation of essential values. Climate activism, especially prevalent in many regions, significantly bolsters the ESG cause. Additionally, civil society activism extends to various countries where human rights advocates promote transparency, particularly concerning gender-related topics.

In North America, movements such as Black Lives Matter have spurred discussions surrounding diversity and inclusion. These localized social movements, with their unique priorities, contribute to different areas of focus within the broader ESG landscape.

In summary, the varying levels of ESG adoption worldwide can be attributed to a combination of regulatory actions, civil society activism, and localized priorities. These factors collectively shape the distinctive trajectories of ESG engagement in different regions.

How have strategic partnerships contributed to the success of ISS? What strategic partnerships do you believe could help take the implementation of the ISS ESG Fund Rating to the next level?

There is a relatively wide field of aspects that I would include under partnerships, but definitely we are part of all the major industry initiatives out there that are focusing on sustainable investing. They exist in countries and geographies and education, and some of them have a more thematic focus such as the environment, whereas others are more focused on geographies. We also partner with other market participants, very often based on our data, so we pipe our data through many different platforms of the large financial data providers in one form or another. We thrive by being on these fund distribution platforms, so if a fund advisor comes to you and you say you have a couple of thousand dollars to invest in a fund, and you ask your advisor where you could invest, the investor might take out an iPad and say: Mr and Mrs Client, here are 20-30 funds you might invest in. This is how they do it from an ESG perspective. We want to be on these platforms; one is FWW, a sister company that provides sub-services, especially in the German-speaking world.

What trends do you see in ESG ratings globally, and how do you see the future of ESG ratings?

There are two fundamental ways in which our investors utilize ESG data: for reporting and for making investment decisions. One notable global strength lies in the increasing sophistication of investors to make precise differentiations based on their objectives. Investors must determine whether they are primarily concerned with risk assessment, impact measurement, reporting compliance, or investment selection. The choice of ESG ratings will vary depending on these specific goals.

On the reporting front, a significant trend is moving toward standardization. Regulators are actively promoting a standardized approach to reporting to enable consumers to make meaningful comparisons. This standardization ensures that clients and consumers can differentiate between companies on an apples-for-apples basis, particularly in terms of their carbon footprint.

Conversely, on the investing side, we are likely to observe a counter trend. While reporting emphasizes harmonization, investors are increasingly seeking individualization. For instance, if you are a European fund manager using ISS ESG ratings to assess the Stoxx 500, your product may appear quite similar to those of other asset managers using a similar approach. To stand out, fund managers are exploring options like creating their own customized ESG ratings based on unique aggregation methods. This divergence fosters differentiation among investment strategies.

In summary, we anticipate a future where ESG ratings continue to evolve, with harmonization being a driving force in reporting while individualization becomes the hallmark of innovative investment strategies.