ESG Ratings: The What, the Why and the How
StepChange Primer. Sidhant Pai, Chief Science Officer, StepChange Inc.
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The ability of a business to function in a sustainable and socially-responsible manner is increasingly considered to be material to its long-term financial prospects. It is thus perhaps unsurprising that the past few years have seen an explosion of newly minted ratings frameworks that revolve around Environmental, Social and Governance (ESG) criteria. These ESG metrics are being deployed as targeted economic levers to help appropriately price the externalities that result from business activities, incentivize more responsible corporate decision-making and guide capital allocations.
Over the past decade, an increasing number of prominent investors have enthusiastically adopted an ESG lens, with trillions of dollars flowing into businesses that are considered sustainable based on this criteria. Governments across the world have started mandating ESG disclosures and many corporations are now publishing their ESG metrics publicly, actively positioning themselves as progressive on these issues. While there is a top-down push from institutional stakeholders to move in the direction of ESG-friendly portfolios, the underlying drive for responsible capital allocation is fundamentally rooted in the grassroots, with many customers, particularly in younger demographics, implicitly or explicitly incorporating ESG filtering into their own spending decisions. These trends are only expected to intensify in the coming years, bringing with them a number of important questions for corporations, consumers and investors.
When the United Nations released its Principles of Responsible Investing (PRI) Report in 2006, 63 organisations signed on, with total assets under management (AUM) of around $6.5 trillion. By 2021, the UN PRI had over 3800 signatories, with over $120 trillion in AUM.
A Brief History of ESG Investing
Socially responsible investing, as a concept, has been around in some form for many decades now. ESG ratings, as we think of them today, were originally developed and deployed in the 1980s to help inform niche investment groups (such as faith-based organisations and social impact funds) that were interested in deploying capital in a manner that aligned with their core values. Since then, the concepts of socially responsible investing (SRI) and sustainable impact investing have gained increasing adoption among large institutional firms and have become mainstream considerations in many regions of the world over the past 5-10 years. In response, the demand for ESG ratings has exploded, with a number of financial data providers now packaging ESG indicators with other financial data streams. ESG ratings are now common-place in the public markets in Europe and North America, where they are displayed alongside traditional indicators like credit-worthiness, forward earnings and market capitalization, influencing trillions of dollars in global capital flows. It is thus imperative that modern business operators understand this rapidly evolving landscape in order to streamline their operations and future-proof their business offerings.
What are ESG Ratings?
ESG ratings leverage a suite of different criteria and metrics to evaluate an organisation (or financial instrument) based on its performance across a set of stated sustainability and value-based objectives. Put simply - ESG ratings are designed to provide quick and accessible guidance to investors that are looking to make more sustainable capital allocations. While there is no standardised approach, most ratings agencies communicate ESG performance using three high-level criteria:
Environmental (E) metrics relate to a company’s impact on the environment (and its ability to mitigate this impact). They span a variety of environmental impacts relating to climate change, air pollution, water usage, biodiversity, environmental toxicity, etc.
Social (S) metrics assess a company’s impact on important facets of our society and cover a variety of related issues by investigating corporate supply-chain impacts, product safety concerns, community impacts, human rights implications, etc.
Governance (G) metrics are intended to investigate a company’s internal processes, covering issues such as board diversity, compensation, transparency, corporate ethics, etc.
While there are important differences, ESG ratings are conceptually similar to other performance indicators (such as credit ratings). Unlike credit-worthiness however, ESG performance is much harder to quantify and the ratings frameworks are much less standardised, resulting in large variations in ESG ratings across different agencies.
How are ESG Ratings Calculated?
There does not yet exist a globally-accepted standardised framework for ESG assessment (though a few are beginning to emerge). However, most major ratings schemes use a set of nested sub-indicators that map to the above-mentioned ESG criteria groupings. For instance, a corporation’s carbon footprint, water-use and waste treatment methods are just a few of many sub-indicators that might be used to calculate its Environment (E) rating. The raw data required to calculate each sub-indicator is either extracted from publicly-available sources or provided directly by the company in question. Once calculated, these sub-indicators are internally weighted and normalised (in a manner that is usually proprietary) before being presented in their final form to the end user - companies, investors, regulatory bodies and consumers.
How are ESG Ratings used by Companies?
Businesses use ESG ratings to:
Baseline their performance and track their progress across a variety of ESG sub-criteria (net-zero goals, diversity goals, etc.)
Identify opportunities to align ESG performance with cost-saving / risk abatement exercises (e.g., improving operational efficiencies to help with climate transition risk in the long-term and energy costs in the short term)
Differentiate their products and business offerings (e.g., Fair trade)
Improve work-force and supply-chain management practices
Future-proof their business models
Build brand recognition and trust among their customers and other stakeholders
Access capital at low costs (e.g., green bonds, impact investments, etc.)
Adhere to regulatory requirements that require ESG disclosures
How are ESG Ratings used by Investors?
Investors use ESG ratings to:
Invest in line with their values and principles
Filter companies based on their ESG performance (or lack thereof)
Identify and invest in industry-leading companies
Decarbonise and modernise their portfolios
Access and deploy capital at low costs
Package and create innovative financial instruments that enable social and environmental impact at systemic scales
What are the Challenges of using ESG Ratings?
While ESG ratings are technically designed to provide quantitative and qualitative insight into a variety of complex performance measures, they are notoriously difficult to validate. The lack of standardisation also means that the methods that are used to calculate these ratings vary meaningfully in terms of the scope of information they consider, the data-sources used to extract this information, the relative weight assigned to each sub-indicator, and the normalisation techniques used to calculate high-level performance metrics across the different ESG criteria. In addition to methodological and data-quality related problems, there is also a strong and perverse incentive for companies and investors to portray the underlying data in an overly positive light, leading to rampant greenwashing.
Future Opportunities for ESG Ratings Efforts
ESG criteria could provide a powerful conceptual framework for informed decision-making, empowering market-based solutions to some of the most pressing challenges we face in society today. However, as implemented today, they are far from effective. At an industry or regulatory level, there is immense value in standardising ESG reporting requirements, making it mandatory for applicable organisations, and providing detailed and transparent guidance on sub-indicator estimation, weightage and normalisation. Investors can play their part by requiring ESG metrics that are independently auditable, validated and science-based. Companies can similarly move the needle by taking concrete steps to establish best-in-class practices relating to transparency and ESG decision-making. If designed, deployed and analysed appropriately, ESG Ratings could become powerful drivers of sustainable and scalable social-economic change over the coming century, making this an exciting and intellectually-fulfilling space to innovate within.
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