Greater ESG rating consistency could encourage sustainable investments

Investors are increasingly applying environmental, social and governance (ESG) factors, in addition to traditional financial analyses, as part of their process to better understand a company’s growth opportunities, material risk and sustainability levels.  

As sustainable investments become mainstream, new tools have developed to assess how companies perform from these new angles and facilitate investment decision-making. One such tool is ESG ratings.

ESG rating providers are predominantly measuring a company’s long-term value creation, particularly aiming to maximize financial value by taking into consideration its exposure to ESG risks based on company ESG disclosures. These ESG disclosures are often non-financial and therefore not reflected in financial statements.

ESG ratings have been seen as a gimmick, as current rating practices are inconsistent with the way they measure a company’s long-term value creation and do not necessarily incorporate a company’s positive or negative impact on the environment or society. This means that investors who rely on ESG ratings can unknowingly be building a better portfolio but not necessarily a better world.

For example, a recent backlash on ESG was sparked by the tweet “ESG is a scam” from Tesla CEO Elon Musk, following Tesla’s removal from Standard & Poor’s (S&P) 500 ESG Index in May 2022, while Exxon Mobil was retained.

According to the Index, which tracks companies based on S&P’s own ESG standards, the fossil fuel major has better environmental, social and governance credentials than the electric vehicle giant.

However, IEEFA’s research shows that this view may not be shared by other rating providers, which indicates differences in rating practices. This report investigates current ESG rating practices and analyses Refinitiv ESG ratings of over 7,600 listed companies as of June 2022. The Refinitiv ratings are used as a proxy to assess the overall trend of the ESG rating industry.

It shows that ESG ratings are wide and conflicting, making them difficult to compare; that clean energy companies may be underrated due to a lack of transparency and subjectivity around ESG methodology; and the ESG rating system is highly reliant on the degree of companies’ ESG disclosure resulting in geographical location and company size biases. It also makes recommendations on ways to address the issues.

Some key findings are as follows:

• Wide-ranging and conflicting ESG ratings. The outcome disparity of ESG ratings between providers stems from the lack of unified objectives and standards for ESG measurements, disclosures and methodologies. The subjective nature of ESG ratings makes them incomparable and difficult for investors to therefore make well-informed investment decisions.
• The “best-in-industry” approach dilutes company-specific ESG performance. Often, ESG ratings reflect a company’s environmental, social, and governance issues compared to its industry peers. For example, Tesla’s score on the S&P Index has remained fairly stable year over year. However, compared to its peers in the automotive industry in which it is assessed, the company had fallen behind resulting in its exclusion from the index. The ESG assessment of a company is more dependent on its industry-specific risk exposure than on its underlying company-specific ESG risk and performance.
• Aggregating ESG scores into a single metric may not be appropriate. Each pillar of the E, S and G scores cover a wide range of factors. Aggregating these elements into a single metric is not an accurate translation of a company’s ESG performance. As a result, a clean energy company, for example, with moderate risk exposure to social and governance issues could be assigned an overall lower ESG score, despite its substantial environmental performance.
• Biases due to geography and company size. Companies that are domiciled in countries with robust ESG regulatory reporting requirements and larger market capitalisation are awarded with favourable ESG ratings. This underscores the over reliance of the ESG rating system on publicly available data disclosures, while companies with sound and sustainable businesses that disclose less ESG-related data could be unfavourably rated.

Given these issues, clean energy companies that fundamentally contribute to reducing greenhouse gas emissions and curbing climate change are not necessarily scoring high “E” or ESG marks, and therefore risk being underrated.

The report makes some recommendations to address these issues including the adoption of universally accepted ESG disclosure frameworks, more transparent ESG rating methodology disclosure by rating providers, a standardized and specific definition of ESG rating, and prioritising impact materiality integration in ESG data reporting and rating, among other considerations.

If ESG ratings are to function as intended to encourage sustainable investments, significant measures to improve and standardize the rating system are needed.