At Fidelity, we believe that sustainability assessments are an essential component of broader fundamental analysis that can add meaningful value to client portfolios, particularly over longer timeframes. This is one of the key factors underpinning our broad commitment to sustainable investing, which we have demonstrated through several fund launches and process developments in recent years.
One of the ways in which investors can integrate sustainability considerations into their investment portfolios is via independent ESG ratings. However, we have perceived some crucial shortcomings among the ratings widely available in the market and believe that these undermine their usefulness to investors. As a result, they do not effectively gauge how companies are managing their sustainability opportunities and risks:
- Most rely on public disclosures, which makes them inherently backward-looking, despite sustainability being a forward-looking endeavour.
- They often lack consistency due to the imprecise nature and varying materiality of ESG issues across companies, sectors and geographies, which makes them inadequate in terms of comparability.
Despite this, our research has shown that superior management of ESG risks can reflect in lower operational risk and higher, more sustainable returns. Meanwhile, companies that do not manage their environmental or social impacts and those with poor governance quality are likely to prove value detractive over the long-term.
As a result, one of the major process developments we have implemented in recent years is the introduction of our own proprietary Sustainability Ratings. These are designed to overcome the shortcomings we have perceived among other ESG rating systems. To accomplish this, the Ratings leverage the three pillars of our approach to sustainable investing and take a forward-looking approach that is driven by corporate engagement, rather than analysis of disclosures.
Three pillars of our approach to sustainable investing
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Source: Fidelity International. Ratings 2.0 rollout beginning Q4 2021.
Broadly speaking, our Sustainability Ratings seek to provide a measure of the degree to which businesses are aligned with the concept of ‘Sustainable Economy’. They are based on our assessments of businesses’ environmental and social impacts, and the ways in which these are governed. We believe that they provide an effective mechanism for investors to integrate sustainability analysis into their portfolios.
Sustainability Ratings 2.0
Despite the success of our Sustainability Ratings to date, we recognise that sustainability is a journey, rather than a destination. As a result, we have been constantly searching for ways to improve the Ratings to increase the value they provide to clients. With this in mind, we took the decision to upgrade the Ratings in October 2021, with the key improvements including:
- A more consistent and comprehensive rating framework, which allows for clearer interpretation and deeper integration of individual sustainability issues within our investment management processes, from research to reporting. This includes a modular approach that allows the addition of new sustainability indicators and the exclusion of obsolete indicators.
Our Ratings also include separate but complementary Trajectory Ratings, as companies with weak ESG characteristics can sometimes re-rate if they are able to improve their behaviour on such issues (we note that lower ESG-rated stocks often appear ‘cheaper’, but this is often because they are subject to higher costs of capital and shareholder outcomes are more uncertain).
- The creation of market-leading sustainability building blocks to allow more granular consideration of sustainability issues. Ratings can also be either absolute or relative, which allows for flexible portfolio aggregation. These improvements are designed to help clients work and measure progress towards specific sustainability goals, while strengthening reporting capabilities to help meet forthcoming regulatory requirements. This includes potentially more stringent SFDR Level 2 requirements, such as Principal Adverse Impacts (“PAI”) reporting.
The improved granularity includes separate Environmental and Social ratings, as well as indicators for the individual factors underlying each of these broader topics. Underlying environmental indicators include energy consumption / emissions activity, water usage, hazardous waste production, biodiversity impacts, etc. Social factors include employee wellbeing, cybersecurity risks, community impacts, ethical conduct, etc. furthermore, certain ‘Universal indicators’ are increasingly considered relevant for all businesses, such as Diversity & Inclusion, while it is also possible to identify and assess Sub-Indicators that fall within the scope of broader topics due to strong client interest / public scrutiny, such as Deforestation (which falls within our environmental indicator Terrestrial Impact).
Our Environmental and Social analysis is supplemented and underpinned by robust evaluations of corporate governance strength. The improved granularity of Sustainability Ratings 2.0 includes separate governance ratings and indicators for the individual factors underlying these, such as management quality (e.g. capital allocation & transparency), ownership structure, checks and balances (e.g. board composition & effectiveness, incentives), etc.
Increasing comparability and granularity of sustainability issues
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Source: Fidelity International. Ratings 2.0 rollout beginning Q4 2021.
