A recent study lays down the gauntlet to SRSI rating and research agencies, challenging them to meet the demands of institutional investors and asset managers. And in doing so, it also sets out guidelines for investors looking for providers of SRSI research and helping them to get the best out of their existing research partners.
The report, ‘Values for money: Reviewing the Quality of SRSI Research’, was prepared by SustainAbility, the longest established international consultancy specialising in business strategy and sustainable development. It was supported by Mistra, the Swedish Foundation for Strategic Environment Research.
The report’s core analysis sets a framework for best practice in SRSI research. It then evaluates a shortlist of 15 SRSI houses in relation to this framework, in order to provide an overview of current industry practice, and highlighting those organisations that represent best practice. These 15 were selected out of a total universe of 35 SRSI and corporate governance research houses internationally, whose core businesses focused on the provision of company research, indices and ratings. (Those companies with consultancy as their core business, as well as inhouse research teams at mainstream financial institutions, were excluded.)
According to the study, SRSI rating and research agencies are facing some tough challenges, as the demand for specialist research houses grows. At the same time, SRSI research itself is at a crossroads. Many agencies have developed a narrow focus, looking at issues of sustainable development and corporate social responsibility. Focusing largely on ethical screening and research, they have defined a rather small niche for themselves. “If they are to succeed in breaking into the mainstream of investment decision-making, it will be essential to prove that their research contributes to financial value creation,” the report asserts.
At the same time, such SRSI issues are moving into the mainstream and are becoming linked to a variety of other concepts, such as reputation risks, corporate governance and even management quality. “The gradual integration of specific elements of the SRSI concept – such as reputational risks, corporate governance (including environmental and social issues) and management quality – into the investment decision processes of mainstream financial institutions can already be observed today,” the report notes. This means that SRSI research is inevitably moving in-house, and therefore independent SRSI research houses have to focus on how they can offer added value.
The way to do this is for SRSI houses – and their clients – to bear in mind ‘materiality’, the potential impact of issues on a company's investment value. “The relationship between key sustainability issues and investment value drivers is clearly vital for SRSI and mainstream investors interested in the financial performance of their investments. Identifying these sustainability issues and understanding how they link with investment value drivers in many ways represents the ‘holy grail’ for this form of analysis.” This is what the report refers to as "second generation" SRSI research.
This is not happening at the current time. The study found that only three organisations in the survey currently analyse the link between social/environmental issues and material impacts on investment value drivers. These are CoreRatings (UK), Innovest (US) and SAM Research (Switzerland).
In addition, most analyst teams in SRSI houses “typically lack the skills needed to address financial and strategic considerations”, and in fact none of the companies studied were judged to exemplify best practice in terms of their research teams. Few analysts had financial qualifications or business experience, particularly with large caps. In fact, eight of the 15 companies had none or only one analyst with relevant financial or large cap experience.
So even though a large number of the research organisations have stated that they are considering incorporating this issue into their future methodology development, as they are constituted now, they may well lack the skills to be able to implement it.
The report also suggests that “many research organisations will have to fundamentally review many aspects of their research methodology and approach”.
While all but two of the shortlisted companies assessed sector-specific issues, the majority lack a customised approach for developing industry-specific criteria. Most simply employ overlays or weighting approaches, running the risk of missing key issues. Three used a process of sector-specific risk mapping.
While the shortlisted companies use of a range of different information sources, including information from NGOs, government sources, labour organisations, the media, and academia, company disclosure was the most significant single source of information, accounting for 40% to as much as 80% of information input. External verification was important to the research houses, but there is a limited availability of third-party verified information, and most rely on the media for verification. In addition, only one company in the survey (SAM Research) had its research process independently verified.
A further limitation is that, as it now stands, the research universe is very limited. There is a “focus primarily on large cap companies based in the developed world. Very few ROs provide any significant coverage of small and mid-cap companies or of companies operating in emerging companies”.
The report calls for institutional investors to play their part in encouraging the development of stringent SRSI research criteria by becoming engaged in the debate. “Those investors with a strategic interest in this field need to better articulate their needs for specialist SRSI research and actively help to shape future developments at a critical time in the evolution of this emerging industry.” Awareness of the framework for best practice will allow investment managers to evaluate the research services provided.
But the involvement of the investment management sector may not stop there. According to the report, “the key to the future development of specialised SRSI research lies in large part with the mainstream investment community”.
SRSI research houses are under growing financial pressure as they are called on to provide more, as competition from in-house research provision grows, and as the price investors and asset managers are willing to pay for research erodes. Meeting the challenges of their evolving industry will not come cheap and may possibly force the industry out of business.
Investors then face a choice: will they choose to support existing groups, or will they set up new research organisations that are better constituted to meet their needs? The report states: “We believe that pension funds, foundations and private investors with a strong interest in specialised SRSI research will in the next years need to finance the transition of some of the leading SRSI research organisations to a more sustainable’second generation’ business model.”