The rating and ranking industry of Environmental, Social and Governance (ESG) data has grown tremendously in the last decades. This type of non-financial data is haunted by a lack of standards, consensus and understanding. ESG ratings and rankings exist to sort out this information for both practitioners and society at large.
We better hope they do a good job as this industry is used by investors to allocate billions of capital, by companies to track their progress and by scholars in their search for the financial relevance of ESG. Given its widespread use, significance and recent questions around their reliability, I thought it would make for an interesting research topic.
According to the Raters initiative by SustainAbility, out of 108 ESG organisations investigated, about 60 per cent need information from companies, such as questionnaires or interviews. This is quite burdensome, especially if you consider that there are currently at least 249 different products that rate, rank or index these companies.
If 60 per cent of those need them to submit information this translates to 149 organisations with questionnaires and often opaque methods of assessment! According to my research, companies spend about half to a full-time post dealing with this, on top of their normal reporting functions (i.e. sustainability report).
Research suggests a lack of convergence between the ratings that companies receive from various agencies. This is not surprising given that there is simply no consensus on what ESG really is. Ratings often consist of hundreds of indicators, making the aggregate score a rather noisy proxy for ESG performance. Making scores even less convergent, are the subjective weights allocated to the different dimensions of ESG.
The questions around the credibility on the one hand, and the widespread use of this industry on the other hand, is reason for concern. If these ratings and rankings are not a good proxy for ESG performance, then billions of capital are potentially misallocated. Another problem is that most of the reported ESG data is not even audited. Therefore, not only the scores are debatable or subjective, but the input information as well. Companies are buried in these questionnaires and they need to make better use of their time.
I must stress here, that the industry has benefits. Investors, for example, tend to rely on ESG scores for efficiency reasons. They face the task of screening hundreds or even thousands of stocks and need quantitative measures to do so. This is why their preference goes out to those ESG raters with most coverage. Others may use ESG research reports to challenge their own viewpoints.
Shareholders should make it clear which [ESG ratings] they find most valuable, in order to allow companies to prioritise. Equally, companies should know what information their shareholders deem necessary.
Although using scores is inevitable for most investors, this does not imply that they are not aware of the pitfalls. In fact, some have established cross-checking methods and will investigate if there are discrepancies for large holdings.
On the company level, there are also indisputable benefits. First off, having their improvement points highlighted, is tremendously helpful. Second, it creates a sense of urgency among top management to get things done. This is especially necessary as, according to my research, investors and companies often fail to have a proper conversation about ESG issues. Discussions are still dominated by short-term financial questions and analysts often lack the training or expertise to talk about ESG. Companies thus tend to use input from ESG ratings and rankings as a proxy for investors’ demand.
Overall, there is nothing wrong with using input from third-parties, but how many of these intermediaries with divergent opinions do companies need to actively engage with? Perhaps a handful is enough? Shareholders should make it clear which ones they find most valuable, in order to allow companies to prioritise.
Equally, companies should know what information their shareholders deem necessary. Sustainability managers should think about what ratings or rankings align with their strategy.
Another possibility is to opt for those with most coverage, as these are the ones investors tend to use. Time can be used to focus their efforts and to communicate the materiality of their ESG progress more clearly, instead of more often.
This discussion is equally important between investors and their clients, as problems may arise if different rating providers are used. Blindly relying on ratings is not a good idea in any case, as (1) rating agencies make mistakes and (2) it is another organisations opinion on what matters.
Stephanie Mooij is Doctoral Researcher at the Smith School of Enterprise and the Environment, University of Oxford. This post is republished from the Corporate Citizenship blog.