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SKAGEN Focus: Looking below the radar to find ESG’s future leaders

The list of companies topping the ESG ratings of providers like MSCI or Sustainalytics contains few surprises. Most are household names and all are among the largest listed business on the planet. Does this mean that they became the biggest through being the greenest or is it just coincidence that the most valuable companies also rank as the most responsible?

Neither is true, of course. A recent study found that ESG ratings are uncorrelated with a company’s environmental performance and CO2 emissions, energy use, water and waste production unsurprisingly scale with company size[1].

Many of the supposed ESG leaders are technology companies which are asset-light but where less visible emissions from things like data centres, servers and electronic waste put the sector’s overall environmental impact on a par with the aviation industry. As these companies have grown increasingly weighty in global stock markets (the tech sector now represents a quarter of the MSCI ACWI Index), so carbon intensity measures have fallen while real-world emissions – which unfortunately can’t be outsourced or passed along the supply chain – have remained flat.


Self-fulfilling bias

There are other reasons why ESG ratings are biased towards larger companies. Scores are determined largely by disclosure and policies which bigger firms are better resourced and staffed to provide. A report last year found that listed companies spend on average between $220,000 and $480,000 on ESG ratings-related expenses annually – a significant cost for smaller companies which are also disproportionately burdened by growing sustainability regulations.

For their part, ESG rating agencies rely on investors for revenues and since there is typically higher demand for large-cap companies to be assessed, this skews their coverage decisions. As well as perpetuating an upward bias, it can mean that smaller companies, particularly those with a market capitalisation below $500 million, aren’t on the radar of rating providers.

For those with sustainable business models, this can be frustrating but can also spell opportunity. Scores are typically based on perceived ESG risks or characteristics and a positive re-rating can drive an equity repricing in the same way that corporate governance improvements historically triggered a favourable share price reaction. The recent growth of sustainable investing where thematic funds allocate capital largely on the basis of company ESG ratings can drive further positive momentum.

This opportunity extends to investors prepared to do their own analysis into a company’s ESG risk profile and trajectory in the same way that a lack of sell-side research can be exploited. Rating anomalies are common at the smaller end of the market where providers are also slow to recognise ESG initiatives and changing company dynamics.

Changing perceptions

The first dimension of this opportunity is to identify stocks where a better appreciation of their strong underlying ESG characteristics could also unlock a valuation re-rating. Many companies providing innovative solutions to help tackle the biggest sustainability issues such as climate change are small and mid-caps. Also, many large-cap companies are reliant on these smaller businesses to reduce supply chain or scope three emissions to achieve their own net zero targets.

A good example from our own fund is Cascades, a $0.8bn circular packaging company that represents 2.5% of the portfolio. The Canadian company, which ranks in the top 20 of the world’s most sustainable companies according to Corporate Knights, uses about 80% recycled material in the containers and tissues that it produces for corporate and residential customers internationally.

Another source of ESG-related alpha can come from small-cap companies in traditional industries where innovation can bring about meaningful reductions in real-world emissions. Cementir, a 2.1% holding in SKAGEN Focus, illustrates this potential. The $1.6bn Italian cement producer inevitably has a large carbon footprint but has committed to reducing CO2 emissions by 30% per ton of cement by 2030 thanks to its innovative limestone and calcined clay technology which removes energy-intensive clinker in the production process. Cementir expects the low carbon cement, which has already been used to build two bridges in Denmark, to reach 50% of sales by 2030, meaning the company could have a very different ESG and equity rating in future. 


The second dimension is the opportunity to engage with small-cap companies on sustainability to help them drive and better communicate their ESG plans and progress. Last year we visited Fortuna Silver Mines, a 2.0% position in the fund, to discuss the company’s climate-related targets and see the positive impact of its Séguéla operations on the local community in the Ivory Coast.

We have also recently been in dialogue with DGB Financial Group as part of SKAGEN’s longstanding governance engagement in Korea to improve company board composition and the protection of minority shareholders. In January we wrote to the company, a 2.1% portfolio position, in support of Align Partners an activist investor which has called on seven of the country’s financial firms to improve their shareholder return policies.

Investors who are willing to go the extra mile will often find small and mid-cap companies that have a low or non-existent ESG rating but are doing much more to manage ESG risks and take opportunities than their larger peers. This is especially true of family-run businesses which usually take a longer-term view of sustainability.

This creates huge possibilities as changes in ESG factors can be powerful equity triggers, particularly as sustainable investing becomes more popular. By finding the right companies at the right prices with a good ESG story and then engaging with them to help spread the word, smaller companies and their investors can become the big winners of the green transition.

[1] Assessments of the environmental performance of global companies need to account for company size, Mastrandrea et al, January 2024.


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