ESG ratings seek to quantify a company’s resilience to long-term industry environmental, social and governance risks and have become increasingly influential in today’s markets. ESG ratings are affecting everything from investment to potential new hires and are being used now more than ever. Despite the huge dependency, the ratings have attracted many critics due to the lack of transparency surrounding methodologies, data sources and potential conflicts of interest by the rating organizations – in some cases the rating organisations also provide advisory services for the companies they rate. Today we’ll look at what exactly ESG ratings measure, how they’re created, and whether they offer any real benefits.
What are ESG ratings?
It is a common misconception that ESG ratings indicate the level at which a company is making a positive impact on our society and planet. In fact, they primarily focus on ensuring investors assess environmental, social and governance risks with the sole intent of maximizing return on investment; they have nothing to do with whether or not a company is positively impacting today’s most pressing issues. In certain cases, companies have been awarded rating upgrades, despite enormous amounts of damaging activity.
What’s working well?
Although controversial, ESG ratings as a concept are sound and, if used effectively, can act as a useful way to encapsulate thousands of different factors into a single measure. Proponents are also quick to point out that whilst they don’t implicitly measure positive impact, by efficiently measuring risk, they can act as a good proxy for positive corporate influence. A huge benefit of ESG ratings is that companies are now having to place an emphasis on anticipating future risks and being forced to focus on sustainable, long-term value creation. Data suggests that companies with a focus on managing their risks, tend to be more efficient, manage their workforce better and have more diverse leadership. In practice, ratings also raise the cost of capital for detrimental companies, which means they have incrementally less financing to cause harm. In short, ESG ratings are there to help identify and understand key issues in a company that cannot be found on a balance sheet but have critical implications on the company, society, and our planet.
What’s not working well?
One of the most significant factors that has led to their scrutiny is the lack of consistency and transparency with which a rating agency assesses. A study was carried out on the S&P500 companies that the MSCI granted an ESG rating upgrade to in 2020 (a total of 155 companies) and it was noted how a business’ record on climate change had little effect on being awarded an upgrade. McDonald’s, despite a significant output of greenhouse gas emissions, were awarded a rating upgrade because their carbon emissions were not included in the calculation; they felt climate change did not pose a risk nor offer opportunities to the company’s bottom line. 51 of the total upgrades were awarded for the adoption of policies involving ethics and corporate behaviour – which included banning already fraudulent crimes such as money laundering, bribery and insider dealing. As a result of their wide use, it has become paramount that rating agencies start to consistently and fairly rate companies as, whilst investors do their own ranking and analysis, a low rating from an established house will put you out of contention.
How are the ratings made?
Formulating ESG ratings proves to be much more complex than most give credit. After all, the agencies have to examine piles of data from countless sources and take into account everything from board diversity to operations endangering wildlife species – a typical rating firm may evaluate companies on as many as 700 criteria. This process is also repeated across thousands of companies in a number of industries, with ever-changing factors and trillions of investment dollars at stake. The agency must also keep the ratings up to date by refreshing them constantly.
Whilst each agency has its own unique way of rating companies, most involve three broad sets of activity.
Materiality
The agency must determine what environmental, social and governance issues are deemed essential to their success or have the potential to create risk. Whilst there is room for commonality among companies in the same industry, analysts must also take into account specifics of individual companies that could substantially affect value creation in the short and long term.
Data Harvesting
Companies do provide the rating agencies with a large amount of information as a good rating can massively benefit the business; however, in cases where data isn’t available (or unwillingly volunteered) rating agencies must resort to regulatory filings, proprietary databases, media reports and a procedure known as imputation. Imputation uses the ingenuity of statistical regression models to predict missing information. This also can act as an incentive for companies to submit their data and is a major factor contributing to inconsistent ESG ratings. Every organisation has their own methodology and programme which create these imputations and even the slightest bias can lead to vastly different assumptions about the same company. In fact, more than half of the data used to create ESG ratings is imputed information and not actually provable.
Scoring
Although each rating organization uses its own evolving methodology for scoring the companies, most assign an overall letter grade similar to those used in credit ratings (AAA,AA,A,BBB…) or a numerical score out of 100. Along with the single score, the agency releases a report detailing a score and justification for each element assessed. Companies are generally only assessed against peers within their industry. This is why we see oil extracting companies ranked higher than others as they have been deemed pioneers for ESG-related issues within their sector.
Conclusion
ESG ratings are a misunderstood practice and primarily act to alert investors of potential environmental, social and governance risks that could inhibit profit. They have come under fire as, due to inconsistency and lack of transparency, many assessment agencies have awarded incongruous ratings with little justification. Due to the trillions of dollars at stake, the industry as a whole is under intense scrutiny as professionals question the process through which these agencies arrive at their scores. Much of this disparity stems from the imputed data that these organisations utilise and despite alleged justification in the reports that follow ratings, companies still feel the whole process is shrouded in mystery.
