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Two Steps Forward

Are ESG ratings really necessary?

Are they leading companies and investors to actually move the needle on the planet’s most pressing problems? If not, why do they exist?

ESG laggard-leader


Third in a three-part series. Read Part One here and Part Two here.

Let’s start by stipulating a couple of things: ESG ratings are first and foremost an independent opinion about the environmental, social and governance risks facing a company and its shareholders, not the risks to people and the planet. And the ratings can also have value as an information resource for capital markets, as well as for customers, suppliers, partners, government agencies — even landlords — to evaluate a company’s strengths and weaknesses.

If you buy that, it begs a question: Don’t credit ratings already do these things?

If you’re not yet sure of the answer, consider this page from S&P Global Ratings about the firm’s traditional (non-ESG) credit ratings, from which I heavily borrowed verbiage for the opening paragraph above:

S&P Credit Ratings … provide your credit credential — an independent opinion of your organization's overall creditworthiness and financial strength. It can be used as an information tool for capital markets participants and your organization's counterparties — banks, clients, suppliers, joint-venture partners, brokers, government agencies — even landlords.

So, if risk is already baked into credit ratings by S&P, Moody’s, Fitch and the other principal credit rating firms, do we really need another set of risk-related ratings? Wouldn’t it be better if ESG ratings and credit ratings were rolled up into a singular system? Will that ever happen?

The short answers: Probably, definitely and eventually.

A bigger, more existential question about ESG ratings is whether they’re fit for purpose, leading companies and investors to actually move the needle on the planet’s most pressing problems. And whether, as some critics claim, the ratings are more of a marketing vehicle for investment firms to generate high management fees than an actual catalyst of positive change.

A bigger, more existential question about ESG ratings is whether they’re leading companies and investors to actually move the needle on the planet’s most pressing problems.

As part of my recent inquiry into the world of ESG ratings, I’ve been pondering these questions, discussing them with those I’ve interviewed and reading some of the growing body of literature that’s critical of the entire ESG ecosystem.

But first, let’s briefly review what we’ve learned so far in this series:

  • ESG ratings are primarily about the risk to companies, not necessarily about their impact, positive or negative, on people and the planet.
  • The methodologies ratings agencies use are complex, and while the raters openly publish them, the methodologies aren’t necessarily understandable by companies and investors, let alone by other stakeholders.
  • The data behind the ratings is also complex, covering hundreds of topics, some of which are subjective. When companies don’t provide requested information, the ratings firms often "impute" it — that is, fill in the gaps with data based on assumptions provided by sophisticated models they’ve built.
  • The ratings can play a helpful role for the rated companies, not just in their external communications but also in assessing themselves, benchmarking against peers and competitors, and identifying opportunities for improvement.

Risk versus reward

The ratings firms I spoke to insisted that the ESG risk information they provide complements traditional financial ratings by providing company information on topics outside their purview.

"It has a very specific use, which is as a supplementary piece of information for investment analysis, and for whether or not these companies will actually face larger risks than what traditional investment analysis is able to find," said Linda-Eling Lee, global head of ESG and climate research at MSCI.

"In the end, it all will converge at some point in time," Kristina Rüter, global head of ESG methodology at ISS, told me. "But for this transition period, we think a lot of input and a lot of learning from the ESG perspective and experience is needed, and will still be needed for a long time, because it's a complementary but completely different approach that involves much more qualitative analysis. Every large investor is using ESG out of the understanding and conviction that the financial analysis does not cover the full scope of risks, and they need this information."

Should ESG ratings firms look beyond risk to include a company’s impacts? Richard Mattison, president of S&P Global Sustainable1, thinks so. "We don't believe that an ESG score should just be about risk," he told me. "I understand that risk is perfectly natural for an asset manager, who remains to be convinced about ESG as a risk argument. Having said that, real-world impact is also important. And frankly, they are linked."

As an example, Mattison cited a company pursuing sustainable agriculture to produce palm oil. Along the way, it invests in protecting the rainforest and taking other measures to ensure the sustainability of its supply.

"That might not be perceived as reduced financial risk by some, because you're not getting any [financial] return from that. But actually, you’re making a real-world impact. If ESG is supposed to be forward-looking, we need to capture the impact side as well as what is traditionally and narrowly viewed as financially relevant indicators from a risk perspective. We think both are important to drive and accelerate progress."

Failing to do that, he added, could create a financial risk over time, should customers or stakeholders press the company to mitigate the environmental damage it’s causing.

"Our thesis has always been that the public is not going to bear that negative externality forever," MSCI’s Lee said. "And at some point, companies have to internalize those costs. So that the companies that are more forward-looking, that are more agile, they can see that. And if they start to incorporate that into the way they run their business and is part of their strategy, then they will be protected when those kinds of costs come to bear."

In other words, today’s negative externalities could become tomorrow’s financial risks, and addressing them now can mitigate both

That’s a significant change from the past, when externalities were exactly that: costs generated by the company that lie outside of its profit-and-loss statement or balance sheet — a.k.a. someone else’s problem. And while the lion’s share of negative environmental and social costs still are socialized — paid for by taxpayers, customers, communities, healthcare providers and others, almost anyone but the company that caused them — the mere fact that they may at least now be accounted for by ratings agencies is a start. An evolution, not yet a revolution.

Shining a light

ESG ratings can benefit companies, not just investors. That’s good news for companies that devote thousands of hours to compiling and disclosing the data used by the raters. A 2020 survey by the European Commission found that companies spend an average of 316 days a year completing sustainability reports and other disclosures, "and an average of 155 days per year responding to and managing sustainability-related ratings and ranking providers."

It's not for naught, Aniket Shah, managing director and global head of ESG at the investment banking firm Jefferies Group, told me. "What ESG has done, and done it more well than poorly, is that it has socialized and educated the financial and business worlds on a bunch of topics that they weren't knowledgeable about before. And maybe it's because I am a part-time academic that I think that education is really powerful."

Today’s negative externalities could become tomorrow’s financial risks.

Evan Harvey, chief sustainability officer at Nasdaq, agrees that the benefits of ratings go beyond the score itself — but only if the company seizes the opportunity. "To me, the ultimate question is, are you evaluating your own performance based on these ratings?" he asked. "Are you organically driving the business towards better goals and more progressive projects and impacts that are positive based on your own analysis? Or are you relying, just like investors are, on these ratings too much in order to estimate your value?"

Some ratings firms are helping companies make better use of the data behind their ratings. S&P, for example, offers a free Corporate Sustainability Assessment to help companies "establish a sustainability baseline and gain independent insight into their sustainability performance relative to peer companies." It invites as many as 8,000 companies a year to participate, although only a few hundred actually do.

Rich Mattison described the process. "If you are a company going through this assessment, you'd log into a portal and see all of this [ESG] information with explanations and help. They get free benchmarking tools to allow them to compare themselves with their peer groups. The companies find this very useful, because it allows them to understand the leading topics of note from our perspective and how they compare with their peers on a number of different elements."

It’s not just an online tool, he added: "We have real people helping companies work their way through this process. It is a bit of work."

Fit for purpose?

The bigger question is whether ESG ratings are truly fit for the purpose for which they were intended. And here, the evidence is mixed at best as to whether highly rated firms produce superior returns, known as "alpha," for investors.

Consider an article published earlier this year by Institutional Investor. The authors — Andrew A. King and Kenneth P. Pucker, academics at the Questrom School of Business at Boston University and the Fletcher School at Tufts University, respectively — concluded that "the logic and evidence for assurances of ESG-driven alpha are lacking. Indeed, it is our best guess that flows of money into ESG funds represent a marketing-induced trend that will neither benefit the planet nor provide investors with higher returns — but might defer needed government regulation."

King and Pucker refuted, or at least provided "logic problems" that counter "four main claims about ESG performance" for companies: that it produces higher profits, signals higher stock returns, reduces capital costs and attracts investment flows.

None of those things is necessarily true, they argued: There is no standard definition of what constitutes good ESG. Ratings firms’ assessments are based on subjective judgments, extrapolation and incomplete data. Many studies that report ESG outperformance are flawed and are based on short-time horizons that are not statistically significant. And "a positive relationship between high-ESG companies and alpha may result from correlation — not causation."

The authors cite acclaimed academic George Serafeim at Harvard Business School, who, among other things, teaches a course called "Risks, Opportunities and Investments in an Era of Climate Change." Serafeim, along with co-authors Michael E. Porter and Mark Kramer, wrote that "despite countless studies, there has never been conclusive evidence that socially responsible screens deliver alpha."

Radical agenda

The criticisms of ESG ratings and investing seem to be growing, perhaps the inevitable backlash to a powerful movement that’s shifted trillions of dollars into ESG-themed funds, toward causes that some dismiss as "woke."

None other than Elon Musk, the entrepreneur and would-be social media maven, has called the current ways of measuring environmental, social and governance issues "fundamentally flawed." And that was among the nicer things he has said. Last month, he tweeted, "I am increasingly convinced that corporate ESG is the Devil Incarnate."

Perhaps. The devil, certainly, is in the details.

In our everything-is-politics world, ESG and climate disclosure are getting their 15 minutes of infamy, at least in the United States. Texas’s top financial official wants to take on giant investment firms — especially BlackRock — for pledging to curb climate change through their investments, saying such climate commitments amount to a "boycott" of fossil fuel companies. The Lone Star State and West Virginia have both enacted financial regulations that aim to divest state funds such as retirement accounts from ESG-minded investment firms. Meanwhile, former Vice President Mike Pence last week called on Republican states to rein in investment funds that are "pushing a radical ESG agenda."

Such pushback "will probably gain steam as midterm elections approach," the New York Times advised.

So, can the ESG ratings world evolve to address the pushback and criticism?

Suzanne Fallender is among the hopeful. "I think in general ratings are at an important inflection point, given that you have so many investors and ratings agencies either relooking at their methodology or new people coming into this space that bring different levels of expertise or perspectives," said Fallender, vice president, global ESG at Prologis and a longtime student of ESG ratings in her previous role at Intel. "And this is against the backdrop of more regulation and standardization of ESG reporting, with a real focus on data quality, assurance, all the internal controls processes. We've been talking about it for a long time, but I think it's really coming to a point here."

In the end, there’s even a chance that ESG risk ratings could merge with the financial stuff.

"I think ESG ceases to be a standalone concept in 2024," Jefferies’ Aniket Shah told me. "I might even revise that and say 2023 because the end goal of all of us had who entered the space was to integrate these ideas into our regulation, into our risk assessment and into the way we think about future opportunities of companies. We are getting close to that because the disclosures are getting better, thanks to the ESG movement."

What will it take to accelerate that kind of singularity?

"The obvious answer is time, which we don't have," Evan Harvey said. "This is a nascent industry and nascent methodology, and trial and error gets us to a better state down the road, as it has with financial metrics. It took 80 years to get to the questionably efficient state that we have now with those. The unfortunate fact is that in this realm we have a deadline, and it's looming. We don't have years and years to get it right."

Thanks for reading. You can find past articles here. Also, I invite you to follow me on Twitter and LinkedIn, subscribe to my Monday morning newsletter, GreenBuzz, from which this was reprinted, and listen to GreenBiz 350, my weekly podcast, co-hosted with Heather Clancy.

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