The challenge of sustainable finance for investors and bankers is to identify companies that are already sustainable or are willing to become sustainable. Over the last decade, there has emerged a large industry concerned with classifying companies according to their environmental and social performance – in other words, on their ESG ratings. But ESG ratings have a number of limitations by design.

Dirk Schoenmaker is Professor of Banking & Finance and Director of the Erasmus Platform for Sustainable Value Creation at Rotterdam School of Management, Erasmus University. He describes those limitations in this blogpost.

First, there is a large divergence among the major rating providers. The correlation between ESG ratings of the major rating providers for the same company is 0.6, whereas the correlation between credit ratings for the same company is well above 0.9. Second, there is a reporting bias. Large companies have more resources to fill in the detailed questionnaires of rating agencies. Third, ESG ratings have little focus on material issues that are relevant to the investee or borrowing company.

The real challenge is to examine whether a company is preparing itself for the sustainability transitions that are underway. Three of these transitions are most important:

  1. the energy transition to fight climate change;
  2. the circular economy transition to save on raw materials;
  3. the agricultural transition to preserve biodiversity.

These transitions have a major impact on the viability of companies. Only companies that can adapt to these transitions by changing their business model will survive. Investors and bankers have to get back to basics and analyse companies’ business models and strategies to see whether companies are prepared for transition.

There are, sadly, some famous examples of companies that were not prepared for transition. IBM did not foresee the move from mainframe to personal computers, and Kodak did not anticipate the move from paper-based photographic prints to digital photography.

Transition analysis starts with an assessment of management quality. Is the board aware of the coming sustainable transition? Are they investing in capabilities? The frontrunners incorporate sustainability in their strategy. The next step is examining the business model and strategy. The final step is monitoring and engaging with the progress of converting current products and services to the sustainable business model.

This looks like the old-fashioned job description for a banker who wants to see the entrepreneur and their business plan before granting a loan. The banker only needs to include sustainability in his credit assessment.

For investors it is harder. They have to roll back from being portfolio managers of a well-diversified portfolio of thousands of stocks to become investors in a portfolio of just a few hundred companies that they know really well.

Transition thinking helps companies (and their financiers) to sharpen their strategy and cope with the major sustainability transitions that are currently happening.

More information

This is a blog from the Erasmus Platform for Sustainable Value Creation at Rotterdam School of Management, Erasmus University (RSM). The Platform aims to enhance knowledge and debate on sustainability in the financial sector. Curious to learn more? Please see our webpage.

Platform for Sustainable Value Creation blog