The Truth About ESG Ratings—and Why Sustainability Reporting Is Crucial for Businesses

Peter Walsh

Some recent news has highlighted the difference between sustainability and ESG, terms that are sometimes equated erroneously. Bloomberg has suggested that the rapidly growing ESG rating business is more about the financial sustainability and viability of the companies rather than the impact of those companies on planet and people.

The authors of the piece focus their criticisms on Wall Street company MSCI. The authors may be right, but let’s make sure we don’t throw the sustainability baby out with the ESG ratings bathwater.

How “Sustainability” Has Evolved and Where It Stands Today

The birth of the sustainability movement can be traced back to the UN’s Brundtland Commission in 1987, where it was defined as meeting the needs of the present without compromising the ability of future generations to meet their own needs. Since then, governments, companies, NGOs, and a range of consultants and service providers have been developing models and practices to meet this objective. Good progress has been made, and many companies have integrated thoughtful and responsible practices into their operations.

The UN established the Sustainable Development Goals, which provide an overarching global framework for sustainability target setting and strategy. A range of other reporting frameworks, methodologies, and standards have since been established as we work towards a common and effective capability to improve sustainability performance.

UN Sustainable Development Goals

Driven primarily by legislation, sustainability is becoming embedded in our economies. Few people would say we have achieved a sustainable business model, with climate and biodiversity both in a state of crisis globally, but we’re heading in the right direction.

What’s Really Driving Investors’ Decisions

The financial sector has been slow to come to the table. The Principles for Responsible Investment was established in 2005, but has long remained a niche movement, with few investors or asset managers seeking to optimize sustainability through their investment decisions. Some funds simply adopted screening criteria, avoiding support for tobacco or arms manufacturing, but were otherwise still quite happy to invest in sectors and business models which clearly had no future in a sustainable world.

The financial community measures sustainability performance through ESG metrics. This is the mechanism it uses to translate real world events, such as carbon emissions or soil degradation, into quantified measures that can be used in financial modelling for investment decision making. A growing number of ratings agencies are using these metrics to develop their own proprietary modelling to evaluate and rank companies, purportedly guiding capital flow to the most sustainable businesses.

This trend has grown significantly, and it’s good news, on the face of it, that the financial community is actively addressing the global crisis we are facing. The flow of trillions into green bonds, the exponential growth of ESG funds, and the recent announcement at the Glasgow COP of a funding commitment of $130 trillion for the decarbonization of the economy are all indicators of this trend.

It is this modelling, however, that the Bloomberg report is questioning, demonstrating that in some cases at least, the ranking bears little alignment with actual performance, and is not effective in directing capital towards good performers.

Where ESG Ratings Fall Short as a Measure of Sustainability

The Aggregate Confusion Project at Sloan School, MIT has been examining ESG ratings. They found that while comparing Moody’s financial rating of a company to the Standard and Poor’s rating of the same company, there was a correlation of 0.92 – both agencies came to similar conclusions about financial health.

The ESG rating, however, had a correlation of 0.61, suggesting widely different views of sustainability performance. They concluded that “ESG data is unstructured, non-comparable, and mostly qualitative: impossible for any machine to evaluate a company’s performance and add value to any decision making.”

The International Organisation of Securities Commissions recently released Environmental, Social and Governance (ESG) Ratings and Data Products Providers Final Report. In its review of ESG rating companies and products, they concluded in part:

  • There is little clarity and alignment on definitions, including on what ratings or data products intend to measure.
  • There is a lack of transparency about the methodologies underpinning these ratings or data products.
  • While there is wide divergence within the ESG ratings and data products industry, there is an uneven coverage of products offered, with certain industries or geographical areas benefiting from more coverage than others, thereby leading to gaps for investors seeking to follow certain investment strategies.

Some argue that it’s OK to have different methodologies, different models, and different views on performance. By understanding how differing conclusions were reached, insight can be gained into the underlying business.

In any event, it’s taken several centuries to develop globally accepted financial reporting standards; the ESG community needs time to develop and optimize this relatively new science. We certainly should be doing all we can to use the power of capital flows to support sustainable development, so the focus of the financial sector is welcome.

ESG Ratings Aside, Reporting Sustainability Data Remains a Business Imperative

The ESG ratings controversy does not reflect more broadly on the sustainability movement, nor on the mandated requirements for ESG disclosure. Organisations all around the world are setting strategies, monitoring their performance, and reporting outcomes, in alignment with globally accepted standards like the GRI and CDP.

With the technology available today, and global awareness, there is unprecedented focus on improving performance. Disclosure of ESG metrics is also being driven by legislators around the world, not least the European Commission with their green taxonomy. This data is generated from the shop floor, from the operations, and if good practice is followed using a sound digital platform, then the output data is complete, accurate and reliable.

This good work will continue. While there may be some concerns about financial modelling used by the ratings agencies, this does not undermine the value and the importance of sustainability data collection and reporting, and ESG disclosure.

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