Will it be better without ESG ratings?
Updated: Nov 21, 2022
Before starting to answer the question of whether our world will be better without ESG ratings or not?
Let's briefly review what we’ve talked about so far in the last two articles.
ESG ratings are mainly concerned with the Risk that companies face rather than necessarily their impact—whether positive or negative—on people and the environment.
Although the majority of raters publicly disclose their rating methodology, they can be complicated and not always understandable.
The information that raters are based on is likewise intricate, encompassing hundreds of topics, some of which are arbitrary. When businesses fail to supply the requested information, rating agencies frequently "impute" it or fill in the blanks with information based on presumptions from complex models they have created.
When it is done properly, the rating is a useful tool for investors and the company itself to benchmark against peers and rivals and spot areas for development.
Does ESG rating mean the same thing as Credit rating?
According to S&P Global Ratings, credit ratings "provides your credit credential - an independent opinion of your organization's overall creditworthiness and financial strength. It can be used as an information tool for capital markets participants and your organization's counterparties-banks, clients, suppliers, joint-venture partners, brokers, government agencies-even landlords."
Does this ring the bell to ESG ratings as well? As ESG ratings are also an objective assessment of the environmental, social, and governance risks to a company, not (just) to people or the environment.
Maybe there is a difference, but it is a blurred line.
What should be the true purpose of ESG ratings?
"We don't believe that an ESG score should just be about risk... Having said that, the real-world impact is also important. And frankly, they are linked."
Richard Mattison, president of S&P Global Sustainable
Should ESF ratings be beyond the risk to include companies' impacts as well? If that is the case, ESG ratings won't focus on return performance or, even worse, "a marketing vehicle for investment firms" but rather focus on changing the course of the world's most urgent issues. Of course, a proper rating is a prerequisite.
ESG ratings as an educational tool
According to a European Commission survey in 2020, companies dedicate an average of 316 days per year to producing sustainability reports and other disclosures and 155 days per year to interacting with and administering rating and ranking organizations that are concerned with sustainability.
So, in fact, during all these times of sustainability concerns, ESG manages to normalize, socialize and educate the business on many topics that before were nowhere near the company's attention. Although there might be some inconsistent ways/methods of education, at least it sheds some light on the way.
Improvement NOT score
As the mentioned problem makes ESG ratings confusing, companies should look beyond the score itself to find other ways to drive their goals and make progress on their impacts. Never should a company rely too much on rating scores. Or in some cases, companies don't believe in ESG rating at all, just like Elon Musk of Tesla.
"I am increasingly convinced that corporate ESG is the Devil Incarnate."
There are also some optimistic minds.
The fact that there are many criticisms about current ESG ratings will help rating agencies to improve their methodology, to make it better - Suzanne Fallender - vice president, global ESG at Prologis. Furthermore, this is on the right track to boost more regulations and standardization of data disclosure.
"Trial and error get us to a better state down the road" - Evan Harvey.
An entirely new rating systems
What do the new rating systems need?
Instead of risks/ return, the new one should address the issues and quantify the genuine impact of business operations on ESG variables, which gauges the costs of the broader "market failures" notion on the economy, people, and the environment. Market failures do include not only effects on the seller and buyer but also a third party that was directly or indirectly harmed by businesses. And third party here, I mean not only human beings but also the environment, the ecosystem as well. The new system should ensure that a company would not get a high aggregate score if it performed poorly on a single factor with significant societal or environmental costs, which is a totally different picture from the systems nowadays.