In the second installment of a series on ESG ratings, Joel Makower, Chairman and Co-founder of GreenBiz, described how ESG scores are determined.
To receive a score, a typical ratings firm sends a company a 300-400 page long questionnaire comprising of short- and long-term topics that may focus on more than 700 different criteria.
Environmental (E) issues include the obvious such as greenhouse gas emissions, other air emissions, water use and discharges, carbon footprint, and policies to end the use of fossil fuels. As well as those not so apparent, such as reliance on declining natural capital stocks, operations affecting protected or threatened species, and susceptibility of facilities to extreme weather events.
Social (S) factors look at human rights issues, child labor, diversity, inclusion, worker safety, family leave policies, and even animal welfare.
Governance (G) issues consider such things as compliance with local and national laws, board diversity, executive compensation, board engagement and oversight of ESG issues, business ethics, conflicts of interest, transparency and accountability, codes of conduct, corruption and bribery, tax reporting and policy engagement.
These, according to Makower, are then broken down into three major buckets of activity:
- Materiality: This determines which ESG issues are deemed fundamental to a company’s financial success or that could create legal, regulatory, or reputational risks.
- Data harvesting: This is the gathering of information about the company from various sources, including the company itself. If companies do not offer data, scoring companies will often impute it, or make “educated guesses…involving statistical regression models, input-output calculations and other techniques.” Makower found that more than half of all ESG ratings are derived from imputed data — not verifiable or actual information.
- Scoring: This is the derivation of the actual number itself, where rating companies weigh and evaluate all the varied data. An interesting fact Makower discovered was that companies are ranked against their peers, not against the entire universe of companies.
According to Makeower, other considerations used to create an ESG score include “a company’s business model, financial strength, geography and ‘incident' history — that is, the number of accidents, lawsuits, fines and other circumstances that could indicate sloppy or unethical practices and, thus, increase risk to a company and its shareholders.”
Frustration over results
Every scoring company seems to have its own evaluation system, which often leads to different scores for the same company.
Evan Harvey, Chief Sustainability Officer at Nasdaq, told Makower that “The most frustrating thing for companies is, ‘The same data goes in ISS, the same data goes in Sustainalytics, and I get two different ratings out. How is that possible? How could one firm say I am a sustainable company and the other firm say I'm essentially on the verge of failing the planet?’”
Also, the process is point-based, so true performance is often not measured.
Whether results are positive or negative, businesses feel that the numbers misrepresent their best efforts.
And if negative, it is very hard to get incomplete or erroneous data corrected, especially once it is in the public domain.
Will ESG ratings continue?
“As someone who observes this space,” Grant Harrison from GreenBiz Group told those attending a GreenBiz webcast on ESG, “I have been surprised at how many people are looking at this data to try to determine what they think about a company.”
In his May newsletter, “Where do ESG and sustainable finance go from here?” Harrison writes: “Insights and advisory consultancy GlobeScan found that 51 percent of American retail investors say ESG has influenced their investments, and 82 percent of retail investors globally say they are interested in investing in companies that are socially and environmentally responsible. But, almost a third say they lack the information required to guide their investments toward socially and environmentally responsible companies.”
Transparency, standardization, and clarity around definitions have others questioning the use of ESG metrics.
Earlier this year, the European Securities and Markets Authority (ESMA) began an inquiry into how ESG ratings work and has raised concerns about potential conflicts of interest.
Also, the U.S. Securities and Exchange Commission (SEC) is scrutinizing how U.S. credit rating agencies compile ESG ratings.
Are ESG ratings needed?
In the third part of the GreenBiz series, Makower asks: “Are ESG ratings really necessary?”
Because ESG is about risk for a company and its shareholders, and not the amount of risk posed to people and the planet, Makower suggests that perhaps they would be better if rolled into a singular system with credit ratings.
ESG scores have caused investors, consumers, and governing bodies to use financial influence to encourage companies to look more closely at environmental, social, and governance issues. This in turn, has forced companies to become more forward-thinking in how their products and supply chains impact the world.
ESG awareness is a way to mitigate climate risk.
However, it has not been easy. Makower cites a 2020 survey done by the European Commission that found “companies spend an average of 316 days a year completing sustainability reports and other disclosures, ‘and an average of 155 days per year responding to and managing sustainability-related ratings and ranking providers.’”
If used correctly, these ratings can help a company evaluate their performance and drive the business towards better environmental and societal goals. Other benefits include a smaller environmental risk factor, and feeling good about helping out the world at large.
But as with most issues in the U.S., Makower found ESG becoming increasingly politicized.
He writes that Texas’ top financial official wants to “take on giant investment firms — especially BlackRock — for pledging to curb climate change through their investments, saying such climate commitments amount to a ‘boycott’ of fossil fuel companies.”
In addition, “The Lone Star State and West Virginia have both enacted financial regulations that aim to divest state funds such as retirement accounts from ESG-minded investment firms.
What does the future hold for ESG?
Richard Mattison, president of S&P Global Sustainable1, sees ESG more systematically integrated into company decision-making, meaning that the scores are more standardized and clearly defined.
“I think ESG ceases to be a standalone concept in 2024,” Aniket Shah at the investment banking firm Jefferies Group told Makower. “I might even revise that and say 2023 because the end goal of all of us who had entered the space was to integrate these ideas into our regulation, into our risk assessment and into the way we think about future opportunities of companies. We are getting close to that because the disclosures are getting better, thanks to the ESG movement.”
So ESG does have a place in today’s corporate world, though exactly where remains to be seen.
