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Finance & Society / Planet
ESG RATINGS MUST DISAGGREGATE ESG PARAMETERS TO REPAIR SUSTAINABLE INVESTORS’
TRUST
17 May 2023
GREEN FINANCE
0
READING LEVEL: EXPERT
READING TIME: 8 MIN.
AUTHOR
PABLO GRANDJEAN
FINANCE WATCH
*
*
*
*
For those who prefer to invest sustainably, an “ESG rating” purports to help
these investors by providing an assessment of investee environmental, social,
and governance policies and impacts. These ratings are intended to identify
ethical investment opportunities. Aggregating E, S and G scoring is problematic
however as it can allow fossil fuel companies to rank as “sustainable”. Only
comprehensive reforms at EU level can repair the trust of sustainable investors.
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policy area
ESG criteria are meant to enable investors to identify and invest in companies
addressing sustainability risks and committed to more responsible and ethical
practices. These criteria are a close cousin to credit ratings. Whereas credit
rating providers assess a company’s risk of defaulting on a loan, ESG ratings
providers assess a company’s integration of environmental, social, and
governance criteria.
Recurring polemics and scandals about ESG ratings are raising doubts about the
transparency of ESG ratings providers. Deeper analysis reveals structural issues
caused by lack of consistent and transparent methodology, rather than incidents
of fraud or miscalculation. ESG ratings providers now confront a growing
scepticism that these ratings may be misused as a fig leaf to repair the image
of polluting companies, misleading investors who want to put their money behind
sustainable enterprises. Such a potentially-powerful tool for sustainable
finance must not enable corporate greenwashing!
ESG RATINGS MUST DISTINGUISH E, S AND G SCORING
ESG criteria assess three variables:
* Environment – the company’s environmental risks and impacts
* Social – the way it deals with its social responsibilities
* Governance – the quality and ethics of the company’s governance
However, instead of scoring each of these ESG parameters and reporting them
separately, as differentiated scores, ESG ratings providers most often will
create a composite of these parameters.
Composite ratings say nothing about the preference and priority given to each
parameter’s score before the provider combines them. Doing so confuses and
frustrates sustainable investors.
Aggregating ESG Ratings into a single composite score, therefore, results in a
contradiction-in-terms. A ratings system designed explicitly to reward
sustainable practices could end up awarding a high ESG rating to a company that
harms the environment, simply because that company has done comparatively well
in implementing good social or governance policies.
ESG rating providers use varying methods to aggregate the ESG acronym’s
parameters – environmental impacts, social impacts, and governance quality of
the rated company – into an aggregated score, meaning that it is virtually
impossible to compare ESG scores from separate ratings providers.
One company’s score can vary considerably, depending on their ESG ratings
provider and the priority given to each parameter by that provider’s particular
ESG rating calculation.
MISLEADING INVESTORS ON SUSTAINABILITY IMPACTS
When thinking of investing sustainably, civil society and consumers assume that
ESG criteria assess “impact materiality” (how business activities impact
communities and the environment). However, most ESG ratings providers instead
assess “financial materiality” (how sustainability considerations affect
businesses). The only dimension considered in most ESG ratings is the companies’
capacity to face ESG-related financial risks and to seize ESG business
opportunities. Most ESG ratings, therefore, are not at all concerned with
whether the rated company is doing business responsibly.
The co-existence of such radically different approaches to measuring ESG
performance leads to blatant contradictions and is an obvious recipe for further
misunderstandings and greenwashing accusations.
How can investors trust a rating when there is still no agreement on what
exactly ESG performance is trying to measure?
ESG PERFORMANCE: ABSOLUTE IMPACT VERSUS RELATIVE IMPACT
Another problem is that ESG rating agencies choose most of the time to highlight
the relative ESG performance of a company rather than its absolute performance.
In other words, if a given company is “Best in class” in its sector (even if it
is the fossil fuel industry), it will appear in ESG portfolios, regardless of
its contribution to a sustainable world in absolute terms.
This confuses and disengages investors: focusing on relative ESG performance
alone means polluting companies can still appear in ESG portfolios, sparking
greenwashing accusations. Absolute performance is far more relevant for
transitioning the economy to a sustainable path and better reflects the
expectations of most retail ESG investors.
FIVE TIMES FEWER HUMAN ANALYSTS IN ESG AGENCIES
Moreover, within ESG rating agencies, each ESG analyst must rate a large number
of companies, leaving little time to understand corporate strategies and
creating a risk of gross misjudgments, like in the case of Orpea. By way of
comparison, providers of more traditional market research have a ratio of
analysts to companies that is five times higher.
This situation is the result of the providers’ business model and of a policy of
minimizing costs in order to maximize margins. This lack of human resources
limits their ability to conduct on-site visits, interview management,
cross-check company statements, and therefore accurately evaluate a company’s
impact on society and the environment.
ESG rating providers should not rely so heavily on companies’ public documents
or on the questionnaires sent to the companies being rated. To properly assess
companies’ sustainability impacts and risks, ESG ratings providers would need to
employ many more analysts than they currently do. The current situation indeed
raises questions about the predictive power that ESG ratings are meant to have.
NO OVERSIGHT ON POTENTIAL CONFLICTS OF INTEREST
Unlike credit rating providers, ESG rating providers can sell consultancy
services to the very companies they rate. They are even allowed to rate their
own shareholders! An absence of rules leads often to conflicts of interest. How
can we trust ESG ratings providers when there is no obligation to prove
independence?
AN OPPORTUNITY TO CHANGE THE RULES
A clear definition of ESG objectives is required to resolve the greenwashing
controversy in the financial sector and for ESG to regain retail investors’
trust.
Clarity on the objectives of ESG ratings providers and high standards for
transparency on their methodology are crucial to allow investors to sort the
wheat from the chaff and invest the way they want. If Europe is to harness
private finance in its path towards a sustainable economy, it urgently needs
minimum standards for the market of ESG ratings.
The European Commission’s upcoming legislative proposal on ESG data and rating
providers (due on 13 June 2023), is the occasion to change the rules in Europe.
Finance Watch published a policy brief in May 2023 to propose clear definitions,
as well as precise recommendations for the regulation of ESG ratings, in
particular with regard to supervisory scope. Some of our recommendations
included:
* The EU’s upcoming regulation of corporate ESG ratings should clarify the
objectives and structure of corporate sustainability assessments.
* Instead of issuing blurry composite indicators, ESG rating providers should
provide separate, standalone ratings for E, S and G factors, in each case
stating if they are assessing financial materiality or impact materiality.
* Corporate sustainability ratings should be aligned with the EU taxonomy,
supervised by ESMA, and subject to high standards for transparency and
prevention of conflicts of interest.
HELP US CHANGE THE RULES FOR ESG RATINGS IN EUROPE
Finance Watch is a European non-profit association created to defend the public
interest in the field of financial regulation. If you enjoyed this article,
remember to subscribe to our newsletter and consider supporting our independent
research with a tax-deductable donation.
If you work for a European NGO or as an independent expert, share our policy
brief on regulating ESG rating providers with decision-makers in Brussels and
consider joining Finance Watch as a member.
Pablo Grandjean
ASSOCIATED PUBLICATION
17/05/2023 Sustainable finance
POLICY BRIEF
POLICY BRIEF – REGULATING ESG RATINGS TO STRENGTHEN SUSTAINABLE INVESTORS
In a policy brief published on May 17, Finance Watch proposes concrete policy
measures to make ESG ratings reliable and meet the needs of ESG investors and
other stakeholders, including...
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