Why are smaller companies poorer performers when it comes to sustainability?

In this blog, we review the ESG performance of large corporations vs. smaller ones.

We take the example of the Oil & Gas sector between Earthstone Energy, a boutique firm with 80 employees, and Exxon Mobil, one of the biggest oil majors with over 63,000 employees.

• ExxonMobil is a global oil major. Its ESG risk rating is 36.5 (High Risk), according to Sustainalytics. It ranks 60 out of 244 compared to its industry peers. Its revenues were $285.6 billion in 2021.

• Earthstone Energy is an oil & gas producer operating in Texas. Its ESG risk rating is 57.8 (Severe Risk), according to Sustainalytics. It ranks 230 out of 244 compared to its industry peers. Its revenues were $419.6 million in 2021, 0.14% of ExxonMobil revenues at the same year.

ESG scores favor larger companies

ESG scores are built by data providers such as Sustainalytics or MSCI ACWI. These ESG rating agencies rely on self-reporting from publicly listed companies. They collect data from sustainability reports, publicly available information, or by sending questionnaires to the companies.

Large companies have dedicated teams that compile their ESG risks and compare themselves to the benchmark. They work on understanding the rating methodologies and identifying the material ESG issues. Once they have figured out the ranking, they can work as hard as possible to provide good and relevant data points to those rating agencies to improve those ESG metrics.

Self-reporting plus greater resources gives an unfair competitive advantage to the larger companies where they can improve their ESG metrics.

Let’s take a look at our two companies, Exxon and Earthstone Energy:

• Exxon has many reports highlighting its actions around sustainability issues: the Advancing Climate Solutions - 2022 Progress Report and the Sustainability report. The information is easily accessible, segmented by topics of interest, and can be quickly processed by analysts.
• Exxon also has a dedicated Sustainability team and media relations team. They can engage at a much more granular level with rating agencies when questions arise and have a dedicated ESG reporting strategy.
• Earthstone also has a dedicated page for Sustainability. Yet they only report on a meager 19 metrics when ESG data consists of hundreds of data points. Their Social and Community consists of a single paragraph, the same for their governance. It is harder for analysts to assess the ESG contribution of Earthstone, likely affecting its ranking.

On top of this, the ESG rating industry has seen an inflation of metrics and scores that need to be reported by companies. This makes it harder and harder for the smaller cap to report on all data points, likely increasing the gap with the larger caps.

For example, smaller caps might have the capacity to audit the company’s carbon emissions but might not be able to do so for their entire supply chain (the same prevails with human rights).

Smaller companies might not also have the aim to create a team writing annual reports (or solely focus on the financial aspect of it).

• In our case, Exxon collects and discloses data on all aspects of ESG metrics 
• Earthstone 19 metrics solely focus on climate change and oil & gas-related metrics (greenhouse gas emissions, gas flared, CO2 emissions, GHG intensity).

And big companies are under greater scrutiny

Greater reporting is key for companies because the bigger they are, the greater scrutiny they get. It is, therefore, crucial for them to distinguish themselves compared to their industry peers.

Asset managers seek to identify all risks associated with the company to make their investment decision. They first start with the financial risks and then dig into the ESG-associated risks. Some ESG investing managers even follow a pure ESG performance strategy. The ESG scores will have a greater weight in their risk assessment decision. If a company drops under a certain ESG score, it might even be kicked out of certain indices.

Because larger companies attract larger investments, shareholders are even wearier of ESG issues. The companies are also more likely to make the news in case of controversy or poor ESG practices. Therefore, if a company does not have a good ESG score, analysts will either engage with the company's board or sell the stock.

One of the best examples of greater scrutiny lies in corporate governance. Bigger firms tend to have more diverse, more independent board members than smaller companies (see below). Investors want to ensure that decision-making in those companies runs efficiently and that they will not run into governance issues. Larger companies are much more likely to be the target of NGOs. Civil society places greater responsibility on them as their impact on our society is much more visible.

• Some members of the Exxon board were replaced after being defeated by activist investors Engine No. 1. The event received a large coverage with large media campaigns relayed by NGOs and activist organizations.
• ExxonMobil is much more diverse board with four women and persons of colors at its board.
• Earthstone only has male seating at its board.

It is hard to quantify whether lower board diversity or lack of resources are the main reasons for reduced ESG initiatives. Because of lower scrutiny, there is less board diversity in smaller companies. This might be a self-reinforcing loop where lower scrutiny = lower board diversity = fewer ESG initiatives, especially on the social side.

Finally, smaller companies have less financial leverage to invest in ESG initiatives

Lower revenues and lower profits affect the capacity to invest in ESG programs. Smaller companies might only be able to focus on issues the most material to them. This is one of the reasons why we often see more DEI initiatives in larger entities. 90% of the 100 biggest companies in the U.S. disclose their DEI statistics, while it is only 55% for the Russell 1000 (1000 biggest).

Smaller companies tend to think about their environmental footprint or their carbon emissions as a priority compared to the social part of ESG:

• ExxonMobil has specific DEI programs to increase its talent pool (especially women and U.S. people of color).
• Earthstone annual report focuses outlines being a top performer in terms of gas flaring, an issue specific to the oil & gas sector. They do not report specific DEI programs.

This seems trivial but paradoxically, employees tend to be happier and feel greater inclusivity in smaller companies. Satisfaction declines with organizational size. Formalized programs seem therefore to aim at regaining the detrimental effects of depersonification of larger firms. Would that mean that smaller firms are unjustly penalised in their rankings? 

Conclusion: there is an unfair approach to ESG for smaller listed companies

Companies’ ESG performance is as much driven by their capacity to report as their capacity to act. ESG disclosures are therefore heavily correlated with the size of companies.

On top of having fewer resources to act, smaller companies are less likely to be listed in indices receiving less attention from investors. They tend to be the laggard compared to their bigger industry peers, taking a narrower approach and not considering all their stakeholders.