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Thursday, February 2, 2023

What to Make of ESG Ratings


The Environmental, Social, and Governance (ESG) ratings market is complex and controversial.  Most ESG ratings provide a score for corporates on how their corporate commitments, performance, business models and structures align with sustainability, social and governance goals, based on different ESG criteria.   

ESG ratings have received pushback from the corporate world for misleading investors and customers.  NGOs like CDP, private companies (like Sustainalytics by Morningstar) and start-ups (like ESGDS (Environment Social Governance Data & Solutions)) are all providing ESG data with significant variation between scores leading many to call out greenwashing, or making false claims that a company or product is environmentally friendly.   

In Sustainability Monitoring in Financial Services, I talked about sustainability monitoring tools helping financial services companies measure the high climate risks of their investments and insureds.  Financial services companies are also demanding high granularity climate risk data from their portfolio companies. 

The good news?  The ESG market is rapidly evolving.   

ESG Ratings 

FTSE Russell’s ESG Ratings and data model allow investors to understand a company’s exposure to, and management of, ESG issues in multiple dimensions (Figure 1). The ESG Ratings are comprised of an overall rating that breaks down into underlying pillar and theme exposures and scores. The pillars and themes are built on over 300 individual indicator assessments that are applied to each company’s unique circumstances. 

Figure 1: FTSE Russell ESG Ratings Category Outline, FTSE Russell, 2022

 

ESG ratings assess a company’s risk exposure to industry-specific ESG risks and how well that company is managing said risk.  On average, a ratings firm will evaluate companies based on ~700 criteria leading to 300–400-page questionnaires.  

What is Their Purpose?  

The rationale behind ESG ratings is that higher rated companies have a lower risk exposure and are more likely to provide a return to shareholders.  ESG ratings do not assess a company’s negative or positive impact or reflect its actual policies or performance.  If a company’s bottom line isn’t impacted by climate change risks it can increase its ESG rating, regardless of its impact. 

Like sustainability monitoring tools, ESG ratings are primarily for investors used to assess the ESG-related financial risk associated with current and potential portfolio companies.  

A March 2022 survey from The SustainAbility Institute by ERM was conducted of U.S. investors and corporates on the costs and benefits of climate-related disclosures.  The study found that 94% (33 out of 35) of investors were spending on average $487,000 annually on external ESG ratings, data providers and consultants.  

Use of ESG Ratings Today 

Companies can use ‘good’ ESG ratings to communicate action on climate change when this claim can be unsubstantiated.  But using ESG ratings as a proxy for sustainability impact investing is flawed. The ‘S’ and the ‘G’ will skew the impact of the ‘E’.  For true sustainability investment ‘E’ should be assessed in isolation. 

There is a lack of transparency, consistency or standardization in data collection or methodologies underpinning ratings, which ultimately impacts quality (Figure 2). 

Figure 2: ESG Executive Survey – Preparing for High-Quality Disclosures, Deloitte, March 2022

 

Over half of the data used to create ratings is imputed, not actual or verifiable information from the company as many companies don’t want to disclose this data.  This may change once mandatory disclosures come into force but mostly in the ‘E’ category and primarily for emissions data.  

Weightings between ESG and the 700 metrics can vary between ratings providers, however this is evolving as models and comparisons to real-world data improves.  Today, however, each model has different weightings, data and assumptions, leading to mistrust.  But companies are generally rated in comparison to their peers rather than to all companies, so oil and gas companies can have higher scores than, say, an EV producer.  

ESG Innovators to Watch 

  • EcoVadis is a developer of technology that ranks companies for environmental responsibility, ethical treatment of workers and other practices.  With large corporate customers like Johnson & Johnson, Nestle, Pernod Ricard, and Henkel, they may be the closest to being a common business sustainability platform, with a universal scorecard, benchmarks and performance management tools.
     
  • ESG Book is a provider of cloud-based services for financial institutions to manage sustainability data.  Touting an equally impressive customer list including Dow Jones, AWS, Accenture, Citi, Google Cloud, and HSBC, ESG book connects investors with companies.  They provide transparent, comparable ESG data for over 25,000 corporates in real-time, allowing you to download data, search companies to see their ESG scores, request and disclose ESG data.
     
  • Nossa Data makes an ESG management platform for reporting, data management and analytics.  Known for their simplicity of ESG reporting templates, they are accompanied by robust analytics.  Whether a company is just getting started with ESG or it is 10 years into their sustainability strategy, Nossa Data uses AI to understand exactly where you are in terms of ESG data and shows you insight to help get to best-in-class ESG disclosure. 

The climate risk analysis and emissions monitoring innovation ecosystems go hand-in-hand for corporates having to disclose their climate impact.  The emissions monitoring or carbon accountancy market is providing corporates and individuals with tools to capture, aggregate and analyze their carbon footprint.  Stay tuned to this important category to see continuous innovation with enabling technologies. 

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