Environmental, Social, and Governance (ESG) criteria have become increasingly important for investors and other stakeholder groups alike. 2020 has been a year of unprecedented events – the COVID-19 crisis, global economies facing recession, civil unrest, worsening climate crisis – which sharpened the focus on sustainability and sustainable investing. The already existing concern around ESG-related issues (mainly, those linked to environment such as the use of palm oil and the size of carbon footprint) have fused with the issues arising out of COVID-19, police brutality and racial injustice to fuel demands by the public for companies to invest in ESG-compliant practices. This is reflected in the growth of sustainable investing, which in turn has a positive impact on both the reputation and the financial performance of a company.
In light of this, it is imperative for companies to monitor their ESG profile, both to identify emerging ESG-related risks before they become material and to present themselves as leaders in this field. This begs the question: is it possible for an organisation to reliably quantify its ESG performance? Before tackling this, it is important to discuss ESG ratings.
What are ESG Ratings?
With huge value and attention being placed on sustainable investing, investors and businesses need an accurate way of measuring ESG performance. ESG ratings offer means fo investors to do just that – by drawing on media stories, annual reports, investment analysis, the outcomes of shareholder meetings, and data on executives. In addition to this, ESG risk and management metrics are examined. From all of this data, a numeric score of a business’ financial risk is drawn – which acts as a proxy of ESG performance.
Of course, as with any other investment class, impact investment should be based on metrics that are objective, transparent and independently verifiable. However, being an area composed of many different elements (from recycling and transparency to diversity policies), ESG measurement is far from being simple. Unfortunately, for those asset owners who are looking to allocate capital with the intention of creating a positive impact, a broadly accepted framework is not yet clear. James Magor, Director of Responsible Investment at Actis, goes as far as saying ESG rating principles are “a baffling array of unverified, opaque and incompatible measurement frameworks”.
Mainstream Frameworks
Many ESG systems have emerged attempting to accurately quantify ESG position. This includes (1) Disclosure Insight Action (also known as Carbon Disclosure Project or CDP), (2) Global Reporting Initiative (GRI), (3) Taskforce on climate-related Financial Disclosures (TCFD) and (4) Sustainability Accounting Standards Board (SASB).
The CDP is an environmental reporting framework for companies (and cities) that is focused on climate change, forests, and water security. The GRI standard requires extensive corporate disclosure against a comprehensive index of ESG metrics. the TCFD recommends 11 standard climate-related disclosures in four areas (governance, strategy, risk management, metrics and targets) – which assess how the company has incorporated the consideration of climate-related risks into various aspects of its governance – thus, allowing investors to judge how prepared a company is for the shift to a low-carbon economy. Finally, the SASB is a set of 77 industry-specific sustainability accounting standards covering material ESG factors for each industry. SASB is considered by Anthesis (the largest group of sustainable experts in the world) to be the best framework for ESG reporting, as it helps produce the most accurate ESG reports.
While the above metrics are being employed and are a good start to defining broader ESG metrics, the measurement and quality of ESG data remains an issue.
What are the key issues with ESG ratings?
The points above make it clear that despite the extensive awareness and a growing enthusiasm for impact investment, there is a lack of a transparent system and recognised methodology which creates many inconsistencies when measuring ESG compliance. These difficulties arise from a number of factors, the most relevant one being the breadth of issues covered by ESG criteria. The framework offers a huge checklist: every social, governmental and environmental action and impact of an organisation. As a result, it is very hard to accurately measure all of these with the existing rating systems. Hence, why many areas of ESG framework don’t have a generally accepted measurement of criteria and are not represented in easily reportable figures.
Another pressing issue is that different stakeholders have different priorities within different ESG areas: shareholders will look for companies that generate profit and offer low risk; consumers – for products that resonate with their ethics; and employees – for a company that aligns with their values. If it is currently impossible to assess all ESG areas with the same scrutiny, whose interests should be prioritised? Usually, the areas that carry the most weight with the shareholders (specifically, private equity investors) tend to be prioritised and therefore, measured in depth. These are also more likely to be included in annual reports and are often covered by mainstream media. According to a survey done by IHS Markit, the top five ESG metrics commonly sought by private equity investors are:
- A formal, overarching ESG policy which provides an overview of a company’s social responsibility and environmental position.
- Assignment of ESG responsibility within the management team, reflecting the level of ESG integration across the organisation.
- A corporate code of ethics to guide management and employees as they carry out organisational objectives.
- Diversity among employees, board members and management, promoting a wider range of perspectives in decision-making.
- A formal environmental policy showing the management team’s ability to monitor and address the environmental costs of the organisation’s operations.
Perhaps the reason why investors prefer the above metrics is that they are more or less uniformly applicable across many industries. While there is a certain value to this, it increases the risk of basing ESG reporting around what can be easily measured, rather than around all of the criteria.
This lack of industry-standard makes different rating systems difficult to compare in a fair way. Furthermore, the data that is used to evaluate ESG compliance is inconsistent and open to dispute, as relying on company’s self-disclosure (encouraged by the WEF) is a recipe for inconsistency. It means accepting that companies will be “marking their own work” and what they are and aren’t willing to report. A good case study to show how unreliable this system can be is Boohoo, the online retailer that had scored highly on ESG factors, and was later exposed for failing to prevent poor labour practices in their supply chain. In the Times article, Patrick Hosking claims that the ethical investment industry is “heading for trouble unless it backs up its fine words with rigorous analysis and action”.
Solutions
In light of the above, it becomes clear that until now the efforts to accurately quantify ESG performance, have resulted in:
- The accumulation of independent rating systems
- Limited coverage of ESG areas (prioritising those important to the private equity investors)
- Reports based solely on what companies are willing to disclose voluntarily
There is therefore a need for other rating methods, both for investors and companies to keep track of the ESG progress. Different solutions have arisen to tackle these issues.
One of the main challenges investors’ face when assessing a company’s ESG compliance is not knowing which criteria to use. New solutions are emerging to address this problem. For example, RiskHorizon draws in global data from SASB to guide investors and portfolio managers through the ESG due diligence process. It is an easy form-based solution that identifies key company risks (based on its industry as well as the location of its assets), and compiles a list of questions that help investors frame their ESG assessment. RiskHorizon then estimates the ESG score of the company based on the answers to these questions.
For firms operating in the EU (regardless of where they are based), The EU Sustainable Finance Disclosure Regulation is set to come into force in less than 6 months’ time. The legislation mandates certain financial institutions to clarify the categorisation of their green products and services in what is considered by the law firm Ashurst to be the most detailed set of obligations to date. Lorraine Johnston, a counsel in Ashurt’s financial regulatory team. believes that the impact of this new regulation is “ambitious and far-reaching”. She adds: “The price for getting implementation wrong can be high – regulatory action, action for mis-selling by customers and reputational damage from accusations of green-washing are just some possible consequences so it’s imperative all businesses are ESG ready come March 2021”. While the new EU legislation seems promising, many businesses are behind on the preparations for the new EU requirements to come into force in March, as a result of COVID-19 and the need to prioritise their response to the pandemic.
According to law firm Burges Salmon, some market participants believe that if global ESG standards are to be established, there must be a process of convergence between different frameworks. We seem to be moving closer to that outcome. On 11 September 2020, five NGOs (including CDP, GRI, and SASB) published a statement confirming their intention to work together towards a comprehensive corporate reporting system. Furthermore, on 22 September 2020, the IBC published a white paper proposing a set of voluntary ESG disclosure metrics, called Stakeholder Capitalism Metrics (SCM), which is based on existing reporting frameworks (especially, the GRI) while incorporating the United Nations Sustainable Development Goals.
Many others believe that in order to cover the volume of data required to measure ESG performance, the use of machine learning and natural language processing (NLP) is needed. The Alva Group believes that new metrics should seek to incorporate the following characteristics to close the current reporting gap:
- Comprehensive data, beyond company disclosures, be they voluntary or mandatory
- Sector-specific ESG topics, classified and weighted using the best industry practice (e.g. SASB standard taxonomy)
- Sector benchmarking, to understand how a company’s ESG profile compares to other businesses operating in the same environment
- Stakeholder specific, to reflect the competing demands and perspectives on ESG topics that different stakeholders have
- Rigorous scoring, both for overall ESG performance as well as the materiality of the ESG issues faced, be they risks or opportunities
- Traceable data, to enable scores and movements to be linked back to their underlying drivers
ESG ratings are currently still unclear and an accurate way of measuring ESG performance is under development. However, advances in this area can be clearly seen. The efforts of NGOs to reach a standardised system suggest that we are moving in the right direction and the EU Sustainable Finance Disclosure Regulation is an example of a framework that should be applied by governmental bodies internationally. Platforms like RiskHorizon which help identify the relevant ESG criteria for each specific company also take us one step closer to reaching a more reliable ESG scoring system. With the growth of ESG concerns, I strongly believe that huge development in this area is to be seen in the near future.