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ESG Rating Agencies Are Not Arbiters of Truth

Updated: Jan 6


 

Quick Takes

  1. ESG is surging in popular appeal and becoming synonymous with Sustainability...this is not entirely accurate.

  2. With this growth, ESG rating agencies are increasingly turned to as objective arbiters of ‘sustainability’...this is wholly inaccurate.

  3. ESG rating agencies exist in service to financial markets and each represent a distinct organizational thesis...they are great at what they do, but what they do is not ‘sustainability’.

  4. Corporate sustainability efforts can be well-served by remaining aware of ESG ratings, but to shape your programs in the interests of these ratings could prove quite problematic over time.

 



Boom Times


ESG is absolutely booming in popularity. Not only does it seem everyone is talking about ESG, but 2021 has also seen record inflows of investments into sustainability/ESG funds--now with over $2 Trillion USD under management in such funds. Interest in ESG, as measured by the daily volume of internet searches (admittedly only a proxy indicator variable, but a fun one nonetheless), has grown over 270% over the past 12 months alone.




With 15 years of experience in the ESG research space, this level of popular appeal is something we always hoped would come about, but yet here we are still somewhat shocked that it actually happened at this scale.


ESG has long had so much potential and now it seems it is achieving sufficient critical mass to actually be able to deliver on this potential. But we do need to be clear on exactly what this potential is.



ESG Ratings...


With so much interest in ESG, one set of formerly relatively-obscure actors is gaining new prominence and near-celebrity: ESG rating agencies.


ESG rating agencies have developed systems of converting large datasets into simple scores and ratings. These rating agencies take in all sorts of data concerning corporate environmental, social, and governance performance and, in turn, produce simple and digestible comparative scores and highlights. Today, when most people say they are aware of ESG what they are really saying is that they are aware of ESG scores and ratings.


But it is critical to remember that these scores and highlights are not objective or unbiased. ESG rating agencies have developed as a service to the financial industry--and to institutional investors in particular. This means their methodologies and perspectives are carefully developed for specific purposes and use-cases, yet today many people are turning to these rating agencies for purposes beyond what they were designed for--this is problematic.


ESG rating agencies, such as MSCI, S&P Global, Sustainalytics, and Refinitiv (as the more popular examples), gather all sorts of company data in the process of coming to a final ESG score and ranking. But the data is only the beginning. Each rating agency has a proprietary process to turn this data into a score. These processes include, and are not limited to:


  1. Weighting data by asset class;

  2. Weighting data by industry class;

  3. Weighting data by market capitalization;

  4. Weighting data by geography;

  5. Weighting data by age and maturity;

  6. Weighting data by reporting frameworks and standards;

  7. Weighting data by thematic materiality;

  8. Treating data within respective organizational theses;

  9. Allowing for a subjective interpretation of data.


Adding to this, not all ESG rating agencies create scores for the same purpose. Some develop ESG scores as risk management while others do so as value generation (and some as a combination of both) for financial market clients.


It is sometimes funny to see headline articles criticizing ESG rating agencies for not all agreeing on the same scores for the same companies. The fact is that rating agencies never set out to harmonize amongst themselves; rather, they set out to sell a competitive service to financial market clients--discrepancies in scores are not only expected but necessary.



...Are Not Sustainability Ratings


ESG rating agencies are actually very good at what they do. The problem is that people are increasingly turning to them to do something they were never designed to do.


The boom in ESG has turned it nearly synonymous with Sustainability. ESG data can certainly inform our understanding of a company’s sustainability, but there is no reason an ESG score should be taken as a measure of a company’s sustainability. Yet in the void of data relating to sustainability, people have increasingly turned to the one source of quantitative data that does exist and hoped it would work (spoiler: it doesn’t).


ESG data is a starting point to develop an understanding of a company’s sustainability. But an ESG score--and one from an established ESG rating agency--is not an objective reflection of ESG data, rather it is a reflection of how a company’s ESG-related performance is anticipated to impact it’s financial performance. ESG scores are not about impacts on people and the planet, they are about how the impacts on people and the planet are anticipated to impact the bottom line.


ESG data is critical to understanding sustainability...ESG ratings and scores serve a different purpose.



Why is This Important to Corporate Sustainability Efforts?


Your corporate sustainability efforts should keep an eye on ESG ratings but should not operate exclusively in pursuit of these ratings for three principal reasons:


First: Your ESG scores provide a quick and accessible example of how an external stakeholder is likely to perceive your performance on environmental, social, and governance issues. This is helpful. But do be mindful that it is an example of how one specific external stakeholder perceives your performance...and this perspective may not be shared by all other stakeholders. Investor relations are important, and you have a key role to play in this file, but you also have a role to play in relations with regulators and legislators, employees, communities, and supply chain partners--and these perspectives are not directly reflected in ESG scores.


Second: ESG rating agencies are entirely subjective. Each agency is free to establish their own methodology and process...as well as to make changes to their methodologies and processes whenever they see fit. ESG rating agencies want to create a product investors are willing to pay for, and what investors will pay for is always changing. Data weightings, filters, considerations, and organizational theses can change at any time, meaning your score can change even if you don’t. You do not have control over the ESG rating agencies, but you do have control over your own sustainability programs.


Third: ESG rating agencies have developed to follow your lead. Their processes all include a review of all publicly-available data and documents. They seek to measure what it is you are doing but they do not provide any goal-posts of what it is you should be doing. It can be helpful to refer to your ESG scores as an iterative mirror for a quick gauge on how you are progressing in your efforts, but, just as any mirror, it provides only a snapshot of a reflection and not a guide to performance.


In Closing


This was long. Longer than anticipated. If you made it this far then we should talk as clearly we are both interested in the potential of ESG, so please do connect with us at your convenience.


ESG can be remarkably helpful and powerful, but we have to be intentional in how we manage ESG if we want to unlock any of its true value.



 

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