Ratings and Rankings: ESG Fundamentals for Pharma Leaders

It’s that time of year again. As companies enter the proxy season, our financial—and, increasingly, our environmental, social, and governance (ESG)—performances are back in the spotlight. For financials, pharma leaders can confidently explain results, ratings, and how they measure performance. But with ESG, it’s often a different story. That’s partly because the business of drug discovery, development, and commercialization is subject to unique risks and opportunities that can be difficult and expensive to measure, and partly because investors and ESG rating agencies use varying methodologies to score company efforts.

How is ESG performance ranked, and by who? How can our understanding of material ESG topics set relevant benchmarks? Is it appropriate to approach ESG ratings with a healthy dose of skepticism? I recently worked with a team to dig deeper. Here’s my take on what we found.

Diverse philosophies and funds

About 54% of Gen Z and millennials hold ESG investments, compared to 42% of boomers and 25% of Gen Xers, according to a 2022 survey by Betterment.¹ However, there’s no “one-size-fits-all” approach, and differing investment philosophies have created three main types of funds:

• ESG-integrated funds consider ESG factors alongside traditional financial ones to evaluate portfolio companies. Funds can include firms with positive and negative ESG ratings.
• ESG-focused funds use forms of negative or positive screening. These funds may eliminate companies based on a set of values (e.g., tobacco companies), behaviors, or controversies. Alternatively, it may include specific companies or sectors considered to have a desirable ESG profile (e.g., renewable energy companies).
• ESG impact funds use a variety of approaches, all with a goal of creating positive effects on society in addition to financial returns for investors.

Ratings driven by social factors

Each of these types of funds may take into account a company’s ESG rating as assigned by one of the major rating providers. Here is where things get more complicated.

Many ESG rating providers use an industry-focused “materiality approach.” In other words, they purport to focus on the issues that are most significant for companies in the life sciences. In practice for pharma companies, that means that social topics tend to be weighted more highly than environmental ones. Highly weighted social topics for pharma include drug access, product quality, talent development, diversity and inclusion, and human rights. The big four rating providers—MSCI, ISS, Sustainalytics, and S&P Global—all place substantial emphasis on these areas.

However, because social and governance factors tend to be weighted more heavily does not mean that there is consistency in approach. Some rating firms value transparency above all else. In other words, so long as a company discloses data, it doesn’t matter much what the data shows. Other agencies attempt to score the quality of a company’s program.

Some rating providers perform their own annual assessments using public information, while others require extensive company-submitted questionnaires and documentation. Some provide the opportunity to review and verify information scraped from the internet; some are also willing to meet with companies to discuss their rating. It is not surprising that results can vary widely. I know of several companies in this industry that are rated as an “ESG leader” by one provider, rated average by another, and a laggard by a third.

Trust and communication

Nevertheless, ESG ratings are here to stay, and pharma companies must navigate the evolving landscape. The real answer for companies is to ground themselves in the realities of their own business and the expectations of their major stakeholders. Some of these issues are common across the industry, but each company’s key stakeholders will vary depending on its product portfolio, geographic footprint, and the research intensity of its business model. In my view, you don’t need to chase the highest ratings across the board; you need to focus on what’s right for your patients and relevant for your business, and then communicate, communicate, communicate!

Ratings can be informative, but ultimately check-the-box governance is not the answer. The right answer is to keep your “north star” front and center. Be transparent about the concrete goals you have set and the steps you are taking to get there.

Reference

1. Retail Investors and ESG: Assessing the Landscape. Betterment. 2022. https://www.betterment.com/hubfs/PDFs/b4c/betterment-retail-investors-esg-survey.pdf