Commentary

ESG Ratings: An Immature Business

Beneath their popularity is a business model that is still just finding its feet, says David Duffy, Co-founder of the Corporate Governance Institute.

ESG ratings are supposed to be a clear window into a company’s financial and ethical performance. Designed to verify and rank a company’s ESG credentials, they typically encompass strategy, risk and opportunity.

Unfortunately, there are still too many variations in the calculation methodologies and almost no clarity on each one’s authenticity, undermining faith in the system as a whole. Regardless of these underlying concerns, investors now look more at ESG factors than ever.

With this increasing focus, what needs fixing about the rating industry to improve trust, and what areas are we most likely to see improvement from?

The issue with ESG ratings

There’s no denying that ESG ratings are an immature business. Compare them to credit ratings, and we can easily see the real problem. The household-name agencies behind credit ratings have developed robust methodologies over decades, giving precise measurements with consistent outcomes. So far, ESG rating agencies lack that level of clarity.

There needs to be more clarity between what ESG ratings are perceived to measure and what they actually measure. Alongside this ongoing confusion about what the ratings represent, more must be done to address the gaps in knowledge around ESG ratings. Education in this sector is available, but unfortunately, uptake remains limited. I’ve long advocated for it to be radically reformed and improved.

Also, without regulatory inspection, providers’ self-serving measures make ratings less credible for everyone; this is one of the most crucial issues that must be addressed in 2024. I remember a few years back when payday loans became all the rage almost overnight. It took nearly a decade for regulatory oversight to catch up; we cannot afford for it to take quite so long when it comes to ESG ratings.

Concerns around greenwashing

ESG ratings represent the most obvious method of measuring a company’s sustainability practices. When, as discussed, these ratings vary widely and include questionable metrics, results could easily be interpreted as greenwashing.

What stops companies from choosing a rating provider they know will give them the most favourable score? As a consumer, I know it’s unlikely that I’ll get a different credit score depending on who I run my search with, so why can businesses get different ESG scores that potentially allow them to overstate their credentials?

Investors and consumers need clarity on where businesses are with their sustainability goals. More than ever, we need ESG ratings to hold companies accountable for their sustainability practices, not a vehicle they can use for coercive greenwashing.

Greenwashing is an urgent problem across almost every industry, which we need to tackle collectively. ESG ratings could be a hugely beneficial tool in governance and investing; they’re just not at the standard they need to be yet.

Improved rather than ignored

Despite the concerns around how ratings are calculated, we now see countless corporate stakeholders, from regulators to investors, chanting for more focus on ESG and jumping to ratings as the critical indicator of success or failure.

It’s important to remember what the ESG acronym stands for. As we all know, it’s environmental, social and governance – a broad spectrum of interlinked factors that directly impact one another. If an obvious alternative solution offered detailed insights into all these core functions of a business, maybe I wouldn’t keep banging the ESG drum – but as of 2024, no alternative comes close.

For this reason, businesses must continue to recognise the importance of ESG ratings, and part of my role as an educator is reassuring industry professionals that even if it’s an immature business, it’s a crucial one.

What does the future hold?

In its recent Spring Budget, the UK government confirmed that it would regulate the provision of ESG ratings. Early in February, the European Parliament and Council approved proposed rules aimed at improving the comparability and reliability of ESG ratings by third-party providers.

We need to see the ESG rating industry mature – and fast. We need the current directionless system of questionable integrity to evolve into a well-respected global authority. That is the only way companies’ ESG efforts can be given the authentic credibility they deserve.

This means we must strive for a more standardised global system to eliminate confusing discrepancies between different rating systems. We also need a more hands-on approach from regulators to give them more legal structure.

Any board that boasts about or relies on an ESG rating to please stakeholders should know how it’s calculated and the intricacies of the source data. If you can’t explain your reasoning, you might be in trouble when the rating gets investor scrutiny, lousy press or worse.

There’s no need to overcomplicate the next steps for ESG ratings: first, we need consistent measurements, but crucially, we need providers to commit to doing what’s best for investors, consumers and the climate – not their clients.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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