In business and investment sectors, sustainability is measured with the help of ESG ratings or ‘Environmental, Social and Governance’ ratings. The environmental disclosures of companies include GHG emissions, waste disposal, energy and water disposal. The social aspect is the labor relations, employee safety, health and product safety and so on. The Governance disclosure has to include board diversity, ethics, shareholder rights, etc. The reliability of ESG ratings is paramount, as investors invest on the basis of these ratings. So how is this sustainability rating generated and how reliable are these ratings? Let’s find out.
What are the methods to determine sustainability rating?
Sustainability ratings are generated externally by third parties depending on the data disclosed by the corporation/s in all the three ESG categories. It is observed that the more information a company discloses, the more the ESG scores tend to be higher. The process of ESG rating is as follows:
There are several standards, which provide the framework for the company to disclose information publicly according to the framework, such as the Global Reporting Initiative and The Sustainability Accounting Standards Board. The companies disclose information through an annual sustainability report or publish it on their website.
To determine the sustainability rating, there are several ESG ratings firms which assess as well as score the disclosures made by the companies, such as MSCI, Institutional Shareholder Services and Sustainalytics. The companies are rated based on their disclosure in the public domain, whether the companies desire the ESG rating or not. The scores are on a 1-100 scale and scandals/ controversies in news or in product areas such as including tobacco, alcohol and gambling are noted while preparing the rating.
Reporting the ratings
Sustainability ratings are then sold by the firms to interested parties such as proxy advisory companies, Bloomberg and mass media. The ESG ratings then can be assessed by investors, asset managers as well as consultants to determine the risks and also the untapped opportunities of various companies.
How reliable is the ESG rating?
As investors are becoming more environmentally friendly, sustainability rating has become increasingly sought after. Strong scores bode well for investors and the environment, as it means that companies would be making an effort to reduce energy use and emissions, especially when they see that more investors are interested in companies with high ESG scores. However, there are some drawbacks in the way the ESG ratings are determined and some unscrupulous companies indulge in greenwashing too. There are some major problems in the way the sustainability rating is measured and therefore, they affect the reliability of the ratings.
The methods and processes which the companies use to collect and analyze data are inconsistent and confusing. Credit ratings agencies are perhaps more transparent in their methods than ESG rating agencies. The former provide input variables, which they use to compute the firms debt rating. However, in stark contrast, a huge ESG rating agency such as MSCI does not use any questionnaires, but relies only on NGO’s public data and government data, as well as 2,100 media sources.
Using the data from various sources, the ratings agencies rate the companies on how environmentally friendly they are. It is not known whether the data is audited uniformly for all companies. The processes have to be more transparent and rigorous to prevent the global temperature from rising by the 2 degrees Celsius decided at the Paris convention.
Assessing the social impact is even tougher, as most companies do not disclose even the labor costs, which is one of the basic data required. To determine the social rating, the rating agencies which find out sustainability rating have to know the details of corporate culture, workforce gender composition, worker training practices, wage disparity between the genders, employee turnover rate and so on.
Governance practices, the ‘G’ part of the ESG are evaluated by observing the role of the shareholders in company decisions.
ESG ratings are often taken at face value, and it is hardly ever questioned why some firms have better ratings than others. These ratings therefore can be greenwashed and are used to claim that a company or firm is more environmentally friendly than it really is. Companies sometimes manipulate the ESG ratings to promote that its products, policies or aims are eco friendly. Sometimes, when the greenwashing is revealed, companies end up paying millions of dollars to rectify their image.
It is not known whether ESG rating firms flag ‘greenwashers’ and identify their greenwashing techniques, which might help investors to stay away from them.
In fact, a recent study found that companies which adhere, or claim to adhere to ESG best practices are actually more likely to encounter regulatory actions and lawsuits.
The companies which have a high market capitalization tend to have higher ESG ratings rather than mid-sized or small businesses. This could be because they have the resources to make the modifications required to earn good ratings.
The area where a company is headquartered matters when ESG scores are handed out. Even though a company’s factories are in developing countries, if they have their headquarters in Europe, they receive a better ESG rating than firms based in US or elsewhere.
Industry sector bias
Composite ratings are unable to capture the differences and risks in business models. When firms in the same industry which have different risk exposure and business models are rated according to the same framework, then the resulting rating would be affected adversely.
Inconsistency of rating
Though ESG ratings are meant to help the investor, these ratings sometimes end up confusing investors, as the same company might have different ratings from different agencies. This is because the agencies do not have uniform rating criteria, scales and objectives.
When there is question as to the reliability of the ESG ratings, then the purpose of the ratings, which is to evaluate the risk as well as to identify the misconduct, is defeated. Until there is more transparency in the process of rating, and a sincere effort by companies to make a difference and become environmentally and socially responsible, the ESG rating will not be able to provide warning signs to investors.