ESG Rating 101 - The Black Box
Updated: Nov 21, 2022
It is never easy to put a single rate on anything, much less three different and complicated things - Environmental, Social, and Governance.
ESG rating is a very daunting task as it deals with a "mountain" of data, and nobody seems to have a clear idea of what happens in that process. Even when the raters like MSCI, Sustainalytics, … publish their scopes and methodologies, it is still a puzzle.
It is not like Raters have clear and concise guidance or, even worse, consistent and trustworthy provided data. Everything is in the hands of Raters - It is a Black box.
"Just because it's published doesn't mean it's understandable,"
Suzanne Fallender, head global ESG, Prologis.
To briefly understand the ESG rating process, let's break it down into 3 main activities that every rating agencies go through before producing its final score.
Materiality: The process of identifying the metrics that matter for a specific business and industry
Data collecting: The process of compiling facts about the business from a variety of sources
Rating: The process of weighing and assessing the information to produce the final score
Identifying the material issues for the company is the first step every rater has to take. According to the Global Reporting Initiative - GRI, material topics are topics that represent the organization's most significant impacts on the economy, environment, and people, including impacts on their human rights (GRI Universal Standards 2021). At the same time, Value Reporting Foundation considers materiality as "a matter is material if it could substantively affect the organization’s ability to create value in the short, medium, and long term.". Obviously, there is already a difference in the way companies see materiality.
Then how to define a company's materiality. Definitely, it is not a simple task. Often, Raters start with the company's sector and sub-sector to form a sector-common risk list that they believe companies share. But this might lead to industrial sector bias and, more seriously, mislead investors' decisions. Companies in the same sector do no necessarily share the same risks since they have different sizes, scopes of operations, or models. Of course, Rating agencies also try to understand this, to go into the unique character of companies as much as possible, but this is another level of difficulty.
What's more? The geographic bias - another problem of defining materiality based on operation location due to significantly different regulations by countries and regions.
2. Data collecting.
Information can be gleaned from a variety of sources, principally the company itself, with additional information gleaned from third-party like media publications, proprietary databases, regulatory filings, and internal research.
So what is the problem?
Data is self-reported
Part of the data is provided by the company itself, especially in the context of no legal requirement; it leaves a huge risk that companies report only the information that fits and benefits them and willingly omit some other important but deficient information about their performance. As a result, these data can very much favor a company's score and help them climb the ESG ladder.
Data from third parties
Another questionable type of data is the one ESG raters get from a third party because it is nowhere near reflecting the actual company's performance but rather an aggregating, no guaranteed quality one from outsiders.
And more important, data from both mentioned sources are unaudited.
So what happens if there is no data available?
ESG rating agencies have to do something to fill in these gaps, which is called "data imputation" - the process of yielding some information base on the regression model, statistical calculation, and so on. These, of course, are not actual data.
Definitely, we should have some trust in the Raters' ability to produce these data. But what happens if different Raters use different methods to impute these data? Which one is better? Which one should investors base their decision on?
Well, at least some agencies, such as S&P, give readers the option of whether or not to include imputed data to view their interested company's score. But it is quite a dilemma for the reader to bear since neither option is really better than the other.
All of these data problem point to one direction - we need regulated ESG/Sustainability reports with mandatory audited processes.
This is the final step to build up the actual ESG scores for companies, in which rating agencies present their own ways as well. The whole 'different methodology" story continues. Some agencies weigh each topic equally, some do not - Weights divergence. Some Raters calculates all topic together, while other prefer to separate them first, etc.
All these divergences make the ESG rating score seem to be less trustworthy. Of course, the ESG rating score could be used as one of the decision-making sources of information. But it should never be the only or the main one for investors to rely on.