Are current ESG ratings an effective way to guide SDG impact?

ESG ratings are imperfect measures of a company’s exposure to environmental, social, and governance risk, and they often ignore the impact that companies have on society. Complete redesign might help, but is that possible?

FinancingGlobal

A flotilla of small boats surround an oil drilling rig in Seattle, protesting Shell's plans to explore the Arctic (Shell subsequently abandoned all Arctic interests). Shell epitomizes the divide between ESG and the SDGs: the company has a high ESG rating but its purpose is incompatible with the aims of the SDGs. © David Ryder/Getty Images

It is boom time for ESG-labeled investment products. According to Morningstar, ESG-labeled funds reached a total of USD 3.9 trillion in assets under management last year.[1] This is out of a total of around USD 103 trillion in assets managed by global fund managers. This money is invested in company shares and bonds across all sectors of the economy. Driven by the proposition that ESG is a way for investors to align their money with their values and achieve similar or higher-risk adjusted returns, ESG and Sustainable Development Goal (SDG)-aligned fund products are among the fastest growing sectors of the investment management industry. ESG ratings are key to this process. So, do more ESG-labeled fund products mean good news for progress on the SDGs?

According to the UN, around USD 3.3 to 4.5 trillion in investment is required each year to finance the SDGs in time for 2030. Yet how do fund labeling and third-party ratings of investment funds and companies as SDG-aligned actually impact on progress towards the Goals? 

ESG ratings have their roots in the system of credit ratings that emerged in the early 20th century in response to speculative investment fever in the United States. However, the two are distinct systems. The role of credit-rating agencies is to provide investors, governments, and banks with a well-recognized opinion on creditworthiness for a wide range of counterparties and financial instruments. Investors rely on rating agencies as cost-effective partners for assessing credit risk. In contrast, an ESG rating is an evaluation of how well a company proactively manages environmental, social, and governance “issues,” and is designed to help investors make sense of the ESG risks (and sometimes impacts – more on this below) of the companies they might invest in. Alongside the typically central place of climate impacts, the social and governance components of these ratings may seek to measure corporate behavior on issues such as labor standards, health and safety policies, gender and racial diversity in the workforce, lobbying practices, and transparent corporate governance, among others.

Materiality questions: corporate vs. societal risks? 

What do ESG ratings actually rate? It is a fundamental question. ESG ratings are primarily based on publicly available data from corporate voluntary disclosure frameworks. Historically, these were the Global Reporting Initiative and the Sustainability Accounting Standards Board. With the growth of ESG reporting, there has been an effort in recent years to consolidate and standardize ESG reporting. The recent launch of the International Sustainability Standards Board (ISSB) – a merger of several other efforts – is meant to achieve just that. But criticism of the ISSB encapsulates fundamental debates about ESG data: what exactly is it, and who does it matter to? 

Broadly speaking, should data reflect how companies’ business prospects are affected by sustainability issues (for example, what is “material” to business and investors)? Or should data reflect how corporate practices affect the environment and society (for example, their impact)? While these occasionally overlap, in practice it’s rarely the case. For example, companies that pollute rarely pay a price for the pollution. Rather, while clients enjoy the benefit of the products, it is society – and the wider economy – that bears the environmental costs: it impacts the wider system. This is a fundamental problem. Ratings focused on ESG “risk to the company” will ignore risks borne by others. ESG carries an implicit promise of making the world better, but ratings do not provide a mechanism to truly deliver on this. 

The challenge is that the consolidation of data reporting is happening around so-called material information. As we can see, it is insufficient to tell a proper story of how companies impact the environment and societies. There are regulatory efforts in the EU to require companies to do both (the term of art is “double materiality”), but this does not extend beyond the region. It is therefore at best an unreliable guide to the SDGs and doesn’t say anything about companies’ contribution to a sustainable economy. 

Stocks and flow: most ESG ratings do not provide a guide to SDG finance

A second, but nevertheless important, nuance to take into account is: what sort of entity is being rated, and does it say anything about financial flows? Here the answer is straightforward: it mostly doesn’t. Most ESG ratings apply to companies that are listed on stock markets: their ownership may change hands (for example, if I sell my Tesla stock to you), but the money does not go to the company. In other words, there is no new money or “additional” investment being made. What this means is that there is no relationship between most ESG ratings and the scale of capital investment that is required to achieve the SDGs: for example, the aforementioned USD 3.3 to 4.5 trillion needed each year to finance the SDGs. There are some exceptions, such as ESG ratings for new sustainability or green bond issues (when a company turns to financial markets to find debt financing for green projects), but these are a minority: the market was estimated at USD 500 billion in 2021. It is poised to grow, although the other definitional and methodological challenges will remain. 

Methodology questions

How is ESG data being tracked? As we have seen, ESG ratings rely mostly on company self-reporting and public information sources. As a result of this process and absent consistent regulation, companies’ reporting can be haphazard. They may be tempted to paper over their most egregious negative impacts on society. Typically, if a media outlet does not pick up on a negative story (a “controversy” in ESG parlance), then the issue will not be factored into ratings. This creates a first risk of bias. The EU is also working to address this from a regulatory standpoint, by asking companies to report on their principal adverse impacts, but this has yet to be implemented and is not present in other jurisdictions. 

A second risk of bias stems from aggregation: current methodologies require ratings firms to amalgamate a huge number of disparate dimensions into a single ESG score. So, a human rights disaster can be quickly outweighed by a new emissions commitment or gender equity policy, and these various SDGs themes are not tracked or compared in a consistent or transparent manner over time. This results in a mushy perspective: it can have some meaning about how companies relate to one another and call out leaders or worst offenders, but it can also be meaningless when it comes to answering whether a company is contributing to the SDGs. 

A third risk of bias is the frequent lack of context for the ESG metrics which underpin the ratings. To give a simple example: water usage (say, by a plant) in an area of water stress is much more significant than in an area where water is plentiful. However, that is rarely reflected in ESG metrics. 

The good news is that there is widespread understanding of the limitations of the current models. Several initiatives, such as the Impact Management Platform, the UN Environment Programme Finance Initiative’s Positive Impact Initiative, or r3.0 and the Sustainability Context Group it manages, are working on providing much more meaningful data. The more challenging news is that the market for ESG data is driven by institutions who do not have the capacity or interest to build a more granular understanding of sustainability data. There is no silver bullet, and improving ESG information will require ongoing advocacy by civil-society experts, and possibly regulation. 

Can conflicts of interest be overcome? 

A potentially larger question looms over the ESG ratings business, as it does over the financial ratings business: most ratings companies sell their research both to investors and to the companies that they rate. The research is often complemented by advisory services. This is not without risk, because it takes a lot of moral fortitude to provide objective information (especially if it’s negative) to organizations one has or courts as clients. 

To wit, the world’s largest credit ratings providers, S&P, Moody’s, and Fitch, continue to dominate the market, years after the 2008 to 2009 Global Financial Crisis. These three giants and a number of their peers have moved into the ESG ratings business, influencing market sentiment and investor approaches to the SDGs. The sector has undergone rapid consolidation, including:

  • Institutional Shareholder Services’s (ISS) acquisition of Oekom Research in 2018
  • MSCI’s acquisition of GMI Ratings in 2014 followed by Carbon Delta in 2019
  • Moody’s acquisition of Vigeo Eiris in 2019
  • S&P’s acquisition of Trucost in 2016 and the ESG rating business of RobecoSAM in 2019
  • Morningstar’s acquisition of Sustainalytics in 2020
  • Deutsche Börse’s acquisition of ISS in 2020

Once start-ups, ESG ratings firms may have seen selling their business to both companies and investors as a business necessity, even a means of survival. The issue is that these conflicts of interest end up being baked into the model once these firms grow or are acquired, because it is hard to let go of an existing and possibly lucrative revenue stream. This creates an overall risk for the quality of ESG information. 

ESG ratings need essential reform

The ESG evaluation market is still young, but its impact on how people consider corporate sustainability practices is considerable. In fact, it now largely defines it. It is therefore essential to improve it. 

But there are larger issues at play: ratings of company or fund-level ESG performance are meaningless without an intention by investors or corporate leaders to achieve change. If companies do not want to support a climate-secure world or gender pay parity, an ESG rating will not alter this reality. Meanwhile a narrow focus on risk factors and materiality in the ESG ratings process can miss wider, systemic issues and trends. These are rarely accounted for in existing rating methodologies and require more research. 

For users of ratings, this means taking things with a (very large) grain of salt. Investors and other stakeholders cannot take ESG ratings at face value. They must invest the time to understand company intentions and capacity to support the SDGs, beyond a rating. They must also invest time and resources in clarifying their own intentions.


[1] Morningstar was obliged to revise this figure, illustrating challenges that this article discusses. 

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