How ESG* analysts should think – Small and private companies get lower ESG score – How to deal with this?

Small companies and/or private companies often get a lower ESG risk scoring, why is this? In this article, I am making abstraction from the fact that many small companies score well on ESG opportunity, particularly those with business in environmental solution, so my focus is here on the risk side of the ESG analysis. Even small companies scoring well on the ESG opportunity side will often at the same time score less good on the ESG risk side.

Do they really represent as a group higher ESG risk? With other words, are their business models really in the long run less sustainable?

I am doing full ESG research on companies on a daily basis; this is on companies that are not covered by Sustainalytics, MSCI or any of the ESG data providers. So there is no quick way or shortcut. Having done around 20 of them during the Corona WFH period, I see where this issue comes from. The question is how should we deal with this bias?

Firstly, where does the negative small and private company ESG score bias come from?

Small Companies, both publicly listed and private, naturally have less employees and less governance. They often also are young and have a business to make fly or to develop with high growth. That takes most of their focus, and most investors would agree that that is exactly what they should do. This results in a lower focus on Environmental (E) or Social (S) topics unless these are part of their business model. The same goes for the Governance (G).

The first an ESG analyst is looking for is whether the company has a policy on E or S topics. Not all have this, but this is after all the easiest part, so many have this actually. This is for example to say there is a zero tolerance for corruption. This is an S policy. Another example is if the company has a policy on waste treatment. This is an E policy.

Fewer have programmes to ensure that employees are educated to understand and be able to live up to the stated policies. This requires more, like schooling in a classroom or e-learning. This takes more time and effort than expressing policies. For instance, using the policy examples above, a teach-in on corruption to make employees able to identify a corruption situation and to stop it. Or an on-site course to make employees learn how to deal with production waste and why.

The last and most powerful element is of course what the company has achieved. Then we look at controversies and relevant KPIs. Are there any known controversies and how are they dealt with by the company. For example, if they have had community problems close to a production site and how this was handeled. Or did they have a corruption case and how have they dealt with this. The problem is that the controversy coverage for smaller companies is very thin if at all, despite several providers proposing this kind of data in the market. Is the company publishing relevant KPIs for their E, S policies? For example can they show that the electricity provenance is getting greener with time? Or that the waste water per produced unit is going down?

If we jump over to the Governance (G) it does not take long time to understand that smaller companies struggle to fulfil the expectations of an optimal setup. As an ESG analyst, I expect to see a good balance of power between the Board of Directors (BOD) and the CEO. I also expect to see a competent, available and independent BOD with good diversity and with the right committees. But this is not easy to put in place for a small company. Who would like to be a BOD member? Everyone, sounds cool! On the other hand, who would you like to have on your board? The perfect BOD member is not that easy to find and it is a selection process. Unfortunately, it is very easy to look in a qualified circle of family, friends and acquaintances. Ending up with a dependent board. If the CEO is the main shareholder on top of that, there is absolutely no balance of power.

For private and family owned companies the Governance is often very dependent and the CEO is in reality part of the BOD that is often not independent at all. Sometimes the CEO and the Chairperson is the same person. Dependent BODs in family companies tend to have many of the other missing parts of a “perfect” BOD also.

Secondly, how to deal with the negative small and private company ESG score bias?

Allright, things are as they are. Small and private companies score lower on E, S and G factors in the ESG analysis. How do we deal with this? First, however you twist this this, it means they have in the current state a higher ESG risk than if this was dealt with in an appropriate way. You cannot come away from this. Not having educated on corruption the personnel that operate in countries where corruption is common is a risk. This can lead crisis for a company. Not having educated the personnel on waste treatment when you have a potential environmental scandal popping up is a risk. Having a dependent BOD that will do all the main owner say is a risk for the minority shareholder, also for a bond investor in a privately owned company.

At the same time, we all understand these smaller companies do not always have the resources to handle this the same way as bigger companies.

So how do we deal with this then?

Here the answer is Engagement. If I as an ESG analyst think the ESG risk in a company is too high for an investment, they only way to make me think differently is through communication with the company. And as I cannot expect them to solve the here above described issues quickly, I would expect at least that they, preferably through a BOD member, show me they are aware of these risks, that they understand this is risk and that they can show me a credible plan how to deal with it. A plan they are ready to communicate publicly and follow up on.

This is really how we do in Engagement for all companies with weak spots in the ESG analysis. The only difference is that for larger companies we are less tolerant, because they have no excuse to expose their shareholders and bond investors to this risk.

Conclusion

Small and/or private companies have structural issues that often leads to lower ESG scores. This is a sign of real ESG risk that investors have to take into account. As these smaller companies often are not in a position to address these issues in a short time span, the way to go is Engagement, with high requirements on credible plans to address the issues and credible follow up. All publicly communicated.

Therefore, in my daily ESG research, I may well end up with an initial low ESG score for a small and/or private company, but through engagement with the company, it may well be adjusted upwards. But without Engagement, it will stay low.

I am very keen to hear what you out there think of this and how you do.

*ESG factors – Environmental, Social and Governance factors