Benchmarking analysis. What is benchmarking? Well, benchmarking is a widely-used technique in ESG analysis, which allows us to compare a company to its peers using a range of ESG metrics. Benchmarking is in fact a technique that many analysts already use in relation to financial metrics. For example, when looking at trading comps or when comparing company profitability. The only difference here is that the ESG metrics are non-financial metrics, such as the level of greenhouse gas emissions or the number of data breaches in a year. The main benefit of benchmarking is that it is an incredibly simple approach to use and understand. It's simply a matter of collecting the data, calculating the metrics, and then comparing the companies. This also makes it very easy to update any analysis when more up-to-date information is available. Also, when this is used across a range of criteria or risks, it helps to identify specific areas of weakness or strength for a company relative to its peers. However, there are a number of challenges when benchmarking and the main one with ESG is that most ESG disclosures are voluntary and, therefore, some companies simply do not disclose sufficient information. Or the information that they do give is not fully comparable with the information from other companies. A further challenge is that some ESG risks lend themselves to more qualitative analysis, such as when considering the adequacy of a company's risk management processes, and this can make it difficult to compare companies on more qualitative issues. A further challenge with benchmarking is that because the quantitative data is typically easier to benchmark, but is usually historic, it can result in analysis which is more backward-looking rather than focusing on the impact on the future operations and earnings of the company. The final challenge with benchmarking is that, in itself, the output of the benchmarking exercise doesn't tell us about the impact on the company valuation. Typically, the output of benchmarking is used to differentiate between two companies that have similar valuation profiles or is the first step in the process of integrating risks into forecasts. Occasionally, investors also use the output of benchmarking exercise as an additional risk factor when calculating the cost of capital, so companies which score poorly on benchmarking are assigned a higher cost of capital. One final point on benchmarking is that there are a number of rating agencies which are dedicated to publishing ESG scores for companies. Well-known ESG rating agencies include MSCI, CDP, Sustainalytics and Refinitiv. Now, the scores that they produce are underpinned by benchmarking methodologies, and each of the rating agencies has detailed frameworks in place for ensuring that the metrics are consistently calculated and appropriately weighted to reflect sector differences. The ratings are widely used by ESG investors to help identify red flags for potential ESG issues, though are rarely sufficient on their own for investors using an ESG integration strategy simply because the investor doesn't have full visibility on how these ESG scores are determined.
