In recent years, investment management firms have been challenged to find the best way to incorporate sustainability data into their investment process.
Although it is great to see that the world is recognising that sustainability factors are material, there has been some confusion as to the reliability of ESG data.
One of the most pointed areas of criticism within the sustainability space has to do with the perceived shortcomings of ESG ratings and scores.
In this blog I will examine some of the opportunities that ESG ratings present as well as some of the more common criticisms they face. I will also outline what the future holds for ESG ratings providers.
What are ESG ratings?
Rating agencies research listed and private companies on a range of ESG criteria. They typically distil their conclusions into a score/rating, either displayed numerically, i.e. a scale of 0–100, or in a similar way to credit ratings, i.e. CCC to AAA.
The research and ratings produced by rating agencies are typically used by investment firms as part of their own company, sector and/or country analysis. The evolution of ratings over time helps the investment community understand how a company is responding to its ESG exposure. Furthermore, ESG reports, scores and recommendations can be used as a basis for engagement with a company, either formally or informally.
The benefits of ESG ratings
They help investors and companies
When an ESG rating agency is launched, believe it or not, its goal is not to confuse investors; it is in fact to help investors identify and understand financially material ESG risks to a business. As the ratings agencies rely on publicly available information, they in turn encourage companies to be more transparent on material sustainable issues which can lead to more sustainable business models, if you believe the mantra “what gets measured, gets managed”.
They can improve decision making
Following on from the above point, a survey of sustainability professionals found that nearly two-thirds of respondents confirmed they took their ESG ratings into account when making business decisions. 72% of corporate respondents reported that they found ratings useful for decision making.
Responders said they track their company’s score across many agencies to identify trends that can inform their strategy. Others used the scores to prioritise action plans and compare their performance against their competitors.
The challenges of ESG ratings
Lack of consistency
This tends to be the most common criticism of rating agencies. Each ESG rating provider uses its own methodologies to collect and analyse data and to produce scores – methodologies which are often quite secretive. The rating agencies are increasingly under pressure to become more transparent, with a few agencies recently making their ratings methodology public.
A number of studies have shown that the correlation/agreement between ratings for different companies is relatively low, implying different weightings to ESG risks and factors by rating agencies, an element of subjectivity and/or susceptibility to the influence of companies during the feedback phase.
One study that suggests this was conducted by MIT, which found an average correlation of only 61% between ESG rating agencies, compared to a 99% correlation between credit rating agencies.
This variation blurs investors’ understanding of sustainability risk and performance at both equity and portfolio level. It also tempts corporations to focus on flattering ESG ratings and ignore indicators of trouble that critical ratings might signal.
Lack of quality data
Another key challenge comes in the form of a lack of objective data. Rating firms tend to rely on self-disclosures from companies or obtain data from third-party sources that is no more reliable than what firms provide themselves. This way, companies have the freedom to pick the issues they want to report and, in some cases, report only the information that fits their agenda.
Furthermore, ESG data is often unaudited. This means it can be hard to identify unsubstantiated claims and inaccurate figures. These issues with data quality mean the ESG ratings can be seen as not showing the whole picture and, at worst, can be manipulated.
ESG ratings are not evenly distributed
Having access to an ESG ratings research base can be expensive and difficult to understand, penalising smaller investment firms, but it also tends to be that larger businesses have greater coverage, impacting smaller companies. Companies with a higher market cap get covered by more rating providers and have their ratings refreshed more frequently, whilst some smaller companies and non-listed companies, as well as businesses from emerging markets, may receive no coverage at all.
What does the future hold for ESG ratings?
So, it is clear that ESG rating agencies mean well, but there are still many downfalls in the ratings they provide. This begs the question: what does the future look like? Below are some of our predictions as well as a look at the new Code of Conduct put forward by the Financial Conduct Authority (FCA).
Growing standardisation can see ESG ratings shine
In a world in which companies are fully transparent and sustainability disclosures are standardised, company self-reporting could be used to create robust ESG ratings that accurately reflect how a business deals with different issues. This could be coming sooner than later.
Although not necessarily a direct regulation on ESG rating providers, the new Corporate Sustainability Reporting Directive (CSRD) introduced by the EU does look to regulate assurance of sustainability reporting and introduces a new EU taxonomy which will provide a “shared understanding of what sustainable means”. This will help to provide some rigour and consistency to ESG scores. Find out more in our blog here.
Furthermore, following the creation of the International Sustainability Standards Board (ISSB) at COP26, the UK is in the process of developing its own taxonomy which is likely to mirror key elements of the EU one. The new UK Sustainability Disclosure Requirements (SDR) will interact with the recommendations or requirements of the Task Force on Climate-Related Financial Disclosures (TCFD), the ISSB and the UK Green Taxonomy to create a single integrated framework helping to better compare business performance and provide assessments.
The role of technology
Great data is out there, but you need to know where to look and how to use it. Sifting through different ESG ratings, as well as public and private data, is a huge challenge. This is where developing technology can play a role.
I won’t pretend to understand the ins and outs of AI tech, data indexing, semantic modelling and machine learning. But technologies are being developed to help quantify qualitative research (which makes up a lot of ESG scores) and the Internet of Things (IoT) is helping to centralise data collection. This automates data collection and allows it to be more efficient and reliable, helping to provide investors with better data and achieve more trusted scoring.
The Code of Conduct
In June 2022 the FCA’s ESG Director said:
We should try to regulate ESG ratings to try to get much more commonality because they’re very important – they’re being used a lot – but there’s also so much confusion.
This has resulted in the FCA appointing a dedicated independent group to work on the development of a Code of Conduct for ESG data ratings and providers. The Code will again mirror developing standards in the EU and will look to be a “globally consistent voluntary code”.
The FCA intends the structure of the Code to be grounded in the International Organization of Securities Commissions (IOSCO) recommendations on the following areas:
- transparency – on methodologies, data and procedures;
- good governance – ensuring methodologies stay consistent and that there are sufficient resources;
- sound management of conflicts of interests – to identify, mitigate, manage and disclose conflicts of interests; and
- robust systems and controls – processes for reporting complaints and misconduct, and for engagement with rated entities.
Is your business AAA ratings ready?
At Design Portfolio and within our impact sustainability consultancy, Ever Sustainable, we are keeping a close eye on these developments and are continuing to support our clients in this time of transition. I don’t think ESG ratings are going away any time soon, but I do think that the standardisation of sustainability data and the incoming Code of Conduct should make things a little simpler for corporates and investors alike.
To learn more, achieve better ESG ratings, improve your sustainability strategy and take your corporate and sustainability communications to the next level, contact us: