ESG Ratings, Friend or Foe?

In recent years investors have shown great importance towards assessing a company's sustainability and ethical performances, and this is done with Environmental, Social and Governance (ESG) ratings. ESG scores typically range from 0 to 100, with a score of more than 70 considered good and less than 50 considered poor. Now with the Environmental, Social and Governance (ESG) scores, companies are using high ESG ratings to divert attention from their poor performance, which is hidden by their low financial reporting quality (FRQ). Investors or regulators look to check the ESG scores because they help them know whether the company they are investing in follows sustainable and ethical practices. Given the significance of ESG performance, global ESG rating agencies have started rolling out important metrics for investors to rely on.

In this blog, we will cover the limitations and potential biases inherent in ESG ratings and give directors a good outlook on how to adopt and critically evaluate these ratings.

Let's first understand the Environmental, Social and Governance (ESG) ratings

In simple words, this rating evaluates a company's performance based on environmental sustainability, social responsibility, and governance practices. These ESG ratings provide a detailed brief on how companies manage their risks and opportunities in these areas. Many prominent ESG rating agencies like MSCI, Sustainalytics, and FTSE Russell employ methodologies to score the company from poor to excellent performance. As interest in ESG performance increases, so does the interest in knowing the ESG behaviour of the firm. According to the data available from the Sustainability Accounting Standards Board (SASB, 2017), 83% of companies registered with the U.S. Securities and Exchange Commission (SEC) disclose some sustainability information in their regulatory filings, mostly voluntarily.

It is often considered that knowing the ESG risks and opportunities of a company can affect the financial performance and the sustainability of the broader economy and society. This has driven investors and policymakers to promote and regulate mandatory ESG reporting. Usually, this trend is pushed heavily by global organizations and initiatives that promote only ESG-related company disclosures. Since we all know that ESG ratings are really important for investors looking to invest in companies that prioritize sustainability and ethical practices, global sustainable investment has reached $35.5 trillion, a 15% increase from 2018 and a 55% increase from 2016. Especially in the US, sustainable investing assets represented 33% of the total managed assets in 2020 (Global Sustainable Investment Alliance, 2021). Financial regulators in the US, Canada, Europe, and Asia are deliberating the expansion of ESG reporting requirements. As of March 2022, the SEC has issued a proposal to include greenhouse gas emissions in public filings and to have them verified by third-party organizations.

Why Do ESG Scores Matter?

Investors prefer companies that boast higher overall ESG scores due to their tendency to have fewer obligations. This aspect makes it easy for them to secure funding and recruit the best talent out there. Secondly, these companies often foster strong relationships with stakeholders and have a positive brand image. These are some of the many things which collectively influence a business’ profitability as well as their financial standing.

ESG scores help investors evaluate various aspects of a company’s practices from how they are towards their employees to how they take important decisions at the board level, as well as how much they prioritize the environmental concerns.

If a company has a good ESG score, it can attract investors well whether due to their mutual values with the company or due to the company’s well-planned risk management of issues like environmental damage or weak governance. Investors who put ESG factors first might be deterred by a company with a low ESG score.

Companies that are not doing so well or who have poor ESG scores are believed to have the most adverse environmental, social as well as governance effects. Unfavorable ESG scores have been linked with increased poverty levels in the areas where the company operates as well as negative impacts on employees’ mental health.

Let's Delve into some of the Limitations of Environmental, Social and Organic rating systems;

One of the primary concerns is that there is no standardization across the rating agencies for the ESG ratings. It is noted that the rating agencies use different sets of processes like methodologies, criteria, and weighted systems leading to super inconsistent ratings of the same company. This causes disparity among the investors and stakeholders who solely depend on these ratings before investing or making any decision in any company. For example, it has been observed that some agencies might rate a company high in its ESG rating but other agencies have given it a low rating as having a different set of guidelines and priorities confusing the investors. Rating agencies must apply assumptions, which adds to the subjective nature of ESG ratings. The European Securities and Markets Authority (ESMA) has reported this issue since the beginning.

Now ESG ratings depend heavily on the availability and quality of data that the companies provide them. Large companies or listed companies have stringent policies wherein they may have to disclose the data while small companies do not have any stringent policies thereby affecting the ESG ratings with a lack of comprehensive data. It is also observed that companies may omit less favourable data and promote selective information, leading to skewed ratings. This heavy reliance on self-reported data is very concerning as it has no accuracy or transparency.

There is a lot of room for bias with ESG ratings. Rating agencies often interpret the qualitative data with their perspective and psyche which is highly influenced. For example, the importance placed on certain ESG factors can vary significantly between agencies, reflecting regional, cultural, or sector-specific biases. Due to this subjectivity ratings do not show the real colors through their ESG ratings.

Here are the different types of bias with ESG ratings;

Company Size Bias: Big companies or listed companies have better resources at hand due to which their ESG ratings are reported on time and in detail. On the other hand, smaller companies have a lack of resources which affects their ratings calculations.

Geographic Bias: Companies in different regions face varying ESG risks and adhere to different reporting standards, introducing biases in ESG ratings.

Industry Sector Bias: Certain industries inherently face more significant ESG risks, leading to lower ESG ratings compared to other sectors. This bias may not accurately reflect a company's actual ESG performance within these industries.

With the ESG ratings environment constantly evolving and developing there are constant upgrades to certain methodologies and practices hence many companies have reported that their immediate upgrades were subject to lag in recognition. A study by the American Council for Capital Formation (ACCF) has highlighted that individual companies and their rating methodologies are not comparable across agencies due to a lack of uniformity in rating scales, criteria, and objectives.

ESG ratings can sometimes not track the data of a particular sector for example; a company may perform poorly in the Environmental sector but might score high on social and governance aspects. Due to this lack of clarity or correct method, the data can be skewed and the performance metrics of ESG ratings can be off at times.

Critical Evaluation Of Independent Directors

Independent directors play a vital role in assessing and overseeing a company’s corporate governance in alignment with long-term strategies and planning. In reality, the independent directors must make informed decisions with the ESG ratings that might retain the interest of the investors. Here are some of the strategies for independent directors;

The main goal of the independent directors is to get familiar with the different methodologies and techniques used by the different ESG rating agencies. This understanding includes knowing the criteria, weightings, and data sources that underpin the ratings. By doing so, directors can better assess the relevance and reliability of the ratings. By having this knowledge the independent directors can start trusting the process of ESG ratings and make an informed decision.

Directors should also try to scrutinize the data that they get through ESG ratings. This includes the source of the data, the accuracy of the information and the transparency with which the reporting process has been done. Companies should be told to follow the discipline of transparent ESG numbers to come up with the right ratings for correct decision-making.

Given the lack of information, process and standardization it is advisable to take information from multiple rating agencies. Independent directors can identify common trends and discrepancies, gaining a more balanced view of the company's ESG performance. With this information, the directors can find the gap through which they can further make an informed decision.

Independent directors can directly tie-up with the rating agencies out there to get a detailed report of ESG metrics and gain insights into the evaluation process. Due to this, they can get to know the process being followed while giving ratings which in turn helps decision making. Open dialogue with rating agencies can also foster greater transparency and accountability.

Rather than relying solely on ESG ratings, independent directors should integrate ESG considerations into the company's broader corporate strategy. This involves getting to know the ESG metrics and making sure they are being inculcated into the culture of the business which in turn helps the company align with the company goals and objectives. This involves setting clear ESG goals, monitoring progress, and ensuring that ESG principles are embedded in the company's operations and culture.

Engaging with a broad range of stakeholders including employees, customers, investors, and community members, can provide valuable insights into the company's ESG performance. Independent directors should consider stakeholder feedback when evaluating ESG ratings and making strategic decisions.

Case Studies and Examples

To illustrate the complexities and nuances of ESG ratings, consider the following case studies:

Case Study 1: Tesla, Inc.

Tesla, Inc. is often lauded for its environmental impact due to its focus on electric vehicles and renewable energy. However, the company's ESG ratings have been mixed, with some agencies highlighting governance issues and labour practices as areas of concern. This discrepancy underscores the importance of a holistic approach to ESG evaluation, considering all aspects of a company's performance.

Case Study 2: ExxonMobil

ExxonMobil, a major player in the fossil fuel industry, has faced criticism for its environmental impact. Yet, the company's governance practices and social initiatives have received positive assessments from some rating agencies. Independent directors at ExxonMobil must navigate these conflicting ratings and prioritize improvements in environmental sustainability while maintaining strong governance and social responsibility.

Conclusion

ESG ratings have the potential to drive positive change in the corporate world by promoting sustainability and ethical practices. However, their limitations and potential biases necessitate a critical approach. Independent directors play a crucial role in this process, ensuring that ESG ratings are evaluated comprehensively and used effectively in corporate strategy. By understanding the methodologies, assessing data quality, comparing multiple ratings, engaging with rating agencies, integrating ESG into corporate strategy, and engaging with stakeholders, independent directors can harness the power of ESG ratings while mitigating their limitations.

Our Directors’ Institute- World Council of Directors can help you accelerate your board journey by training you on your roles and responsibilities to be carried out efficiently, helping you make a significant contribution to the board and raise corporate governance standards within the organization.