ESG Scores and Ratings
ComplianceFinanceJune 10, 2022

ESG: To Score or Not To Score. That Is The Question

“ESG is a scam,” tweeted Tesla CEO, Elon Musk, after the electric car maker was recently dropped from the Dow Jones Indices S&P 500 ESG Index.

This may seem counter-intuitive, considering what the company brings to the table in its efforts to lower global dependency on fossil fuels.

However, in an interview with Reuters, Margaret Dorn, S&P Dow Jones Indices’ head of ESG indices for North America, stated “Factors contributing to its departure from the index included Tesla’s lack of published details related to its low carbon strategy or business conduct codes.” In addition, there have been claims of racial discrimination, as well an on-going investigation of Tesla’s autopilot technology after several fatal crashes.

Chevron, Delta Air Lines, Johnson & Johnson, and Facebook parent Meta met with a similar fate, while companies such as Phillips 66 and ExxonMobil were added to the list.

What is ESG?

The Environmental, Social, and Governance policies and performance of a company determine the fate of trillions of investor and consumer dollars. Even job seekers may use these to determine where they wish to spend their talents.

But what do they mean? How are they derived? Do they do what they were intended — to encourage businesses to pay attention to how a product impacts our environment, society, and world at large, instead of just the bottom line?

Such was the focus of a recent GreenBiz three-part series on ESG ratings written by Joel Makower, co-founder and Chairman of GreenBiz. Makower spent the last few months studying the subject, speaking with experts in the field — both from the investor and business point-of-view.

His findings surprisingly echo Elon Musk’s frustrations — that while well-intended, and serving a purpose, it may be time for a different approach to how ESG ratings are handled.

What are ESG Ratings?

ESG scores “are created by both commercial and nonprofit organizations to assess how corporate commitments, performance, business models and structures align with sustainability goals,” Makower writes. “They are used, first and foremost, by investment firms to screen or assess companies in their various funds and portfolios.”

They also may be used by job seekers, social-minded consumers, and companies themselves to understand where they stand according to “societal expectations and planetary boundaries.”

At the moment, these ratings seem incredibly important. The score helps determine such things as the cost of capital or whether a company’s stock will be included “in any of the hundreds of ESG-themed mutual funds or exchange-traded funds."

They may also be used by media organizations in compiling lists of the best and worst sustainable companies. Or by watchdog groups to identify greenwashing; and by job seekers or consumers to decide which companies and products to pursue or avoid.

“The ratings firms may also confer special status to highly rated companies,” Makower writes.

Who Decides the Score?

There may be as many score-rating agencies as there are definitions for ESG, but according to Makower, there are primarily five that most of the companies he spoke with used:

  1. ISS ESG, a division of Institutional Shareholder Services, a proxy advisory firm
  2. Moody’s, the venerable credit rating company
  3. MSCI, which publishes hundreds of indices for global investment markets
  4. S&P Global, the financial analytics firm best known for its stock indices
  5. Sustainalytics, a division of Morningstar, which provides an array of investment research services

Others include Bloomberg ESG disclosure scores, Fitch Climate Vulnerability Scores, FTSE Russell’s ESG ratings and CDP’s climate, water and forest scores.

Financial Risk Only

All of these “grade” a company. Unfortunately, these “grades” may be flawed.

In a GreenBiz webcast, “Where do ESG and sustainable finance go from here?” Allison Binns, PhD, Head of ESG at Angelo Gordon, says that ESG scores are so random and based on someone’s point of view that they are not universally useful.

In addition, even if a company has made strides to improve, because of the immense amount of paperwork needed for proof, it may not be able to get their score altered to reflect these actions.

Then there are businesses who have excellent policies in place, but do not adhere to them.

For this reason, Makower says, “ESG ratings do not necessarily measure whether a highly rated company is an actual leader in reducing its impacts on people and the planet, or whether it is working to build a more just and sustainable world.”

Instead, it reflects only financial risk. This is something that is widely misunderstood.

He quotes Aniket Shah, managing director and global head of ESG at Jefferies Group, the investment banking firm, as saying, “ESG has nothing to do with making the world a better place. It’s a very tough thing for me to say. This is not why I came into this space myself. What ESG has to do within the capital markets is ensuring that you, as an allocator of capital, understand the risks associated with environmental, social and governance issues from the perspective of how you make the most amount of money in your investments?”

Companies and investors that understand the true meaning of ESG do benefit, however.

Investors feel good knowing that their money is being used by companies that are less at risk from climate change, for example; have a more flexible supply chain and have business practices that may benefit society or lessen the world’s carbon footprint.

For a company, the ESG score can help build its brand, help attract talent, and aid in discussing where the company is heading with employees and executives. In short, a “good” rating makes a company look good.

However, because one is working with numbers, a company may also get assessed and rated on similar factors with a company whose products and business practices don’t necessarily align with one’s own. That may downplay the assessment a bit.

Also, it should be noted that companies are compared to each other within their industry, rather than with each other. For example, ExxonMobil may get high ESG marks within the oil industry. But its score should not be compared with Apple, for example.

“ESG is an imperfect signal,” S&P Global Sustainable1 President, Rich Mattison said in the GreenBiz webcast. But for now, it is “one we have to live with.”

The horizon may be shifting, however.

Back To Top