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July 27, 2021updated 21 Feb 2022 11:11am

More attacks on ESG ratings as sceptics sharpen knives

The spotlight is on publishers of ESG ratings with a recent damning critique coming from a prominent academic claiming their model should be ripped up. But laying the blame solely on rating agencies gives asset owners a free pass they don’t deserve.

By Daniel Flatt

ESG ratings

Green tape: are ESG ratings helping or hindering our chances of creating a better world? (Photo by Dmitry Zimin/Shutterstock)

  • Current ESG ratings set the bar far too low in describing good corporate citizens, a New York University business professor claims.
  • His comments come as major institutions such as IOSCO are weighing in on the debate questioning the viability of the existing model.
  • It is difficult to eradicate subjectivity from ESG ratings. Asset owners must conduct their own due diligence that aligns with their priorities.

With European Union regulatory oversight potentially in the offing, a body of academic research pointing to methodological weaknesses, and, just yesterday (26 July), the International Organization of Securities Commissions (Iosco) raising its own concerns about their “lack of transparency… and uneven coverage of products”, providers of ESG ratings are under intense scrutiny to up their game.

A particularly damning account of the business appeared on 14 July in the Stanford Social Innovation Review, a publication affiliated with the US’s Stanford University. The short article is entitled ‘The world may be better off without ESG investing’.

The author Hans Taparia, a business professor at New York University, kicked off his withering attack on the $40trn sector by asking: how can Phillip Morris, a company that sells 700 billion cigarettes a year, become a constituent of the Dow Jones Sustainability Index North America?

It’s a fair question. Taparia argues that the answer is a simple one and lies squarely at the door of ESG rating agencies. To distil:

  • Rating agencies don’t rate corporate responsibility but instead measure the degree to which a company’s economic value is at risk due to ESG factors.
  • Each rating agency applies its own weights based on factors it deems material. This is subject to human judgment and affected by limited access to necessary information.
  • The body of research compiled to show a positive link between ESG performance and financial performance is based on existing ESG ratings, which have a “very low bar” for good scores.

If ESG ratings must exist, Taparia posits, they should be predicated on factors that measure the economic, human and environmental costs of “market failures” caused by corporations. As examples of market failures, he points to monopolies, “negative externalities” (where a third party is directly harmed by a specific company), and environmental damage.

Taparia is sceptical that agencies would adopt such a model. After all, he says, doing so would lead to a sharp relative drop in corporate ESG ratings, depriving many companies of the large investment flows, lower cost of capital and positive publicity that accompany them.

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A low ESG ratings bar

The academic’s take is clear: “The bar for what constitutes a good corporate citizen is abysmally low and may have made ESG investing, arguably the hottest trend in investing today, a greater force for destabilising society and the planet than if it didn’t exist at all.”

It is hard to prove whether ESG investing is as destabilising as Taparia suggests, but his views have merit and demand further analysis. If the ratings that underpin the investment opportunities fail to effectively inform investors about what they are buying into, then their ability to do social and environmental good is clearly impaired.

But, as far as Capital Monitor is concerned, the buck does not stop with ratings. As a vital corporate check and balance, asset owners must ask themselves whether they are facilitating a light-touch approach to ESG by not asking enough questions about their investments.

If investors are aware of the inadequacies of ESG ratings – and there is evidence that many should be – but choose to ignore them and invest regardless so as to be seen as “green”, then they are part of the problem and not the solution.

No doubt some investors are keen simply to tick ESG boxes to keep the regulators, stakeholders and the press off their back. But Capital Monitor has spoken to many influential asset owners on this subject and it is clear that a large number do not sit in this camp – they would prefer to make a difference and want to track the real-world impact of their investments.

At the moment, as Taparia implies, there is a creeping suspicion that rating methodologies are calibrated to assign higher ESG scores to well-known, liquid and large-cap brands.

A sobering point to raise here is that most institutional investors are reluctant to invest in “smaller” names, where corporate governance and market liquidity remain barriers to investment. Like it or loathe it, you know where you are with Phillip Morris. To this extent, ratings reflect the flaws of the capital markets as they currently operate.

An oversimplification

At the heart of the issue is: can a string of letters such as AA or BBB ever achieve everything that investors are looking for in respect of measuring ESG impact?

The answer is very simple: no.

Why? Because the exam questions we are setting ourselves today are so much more complicated and ill-defined than ever before. We are not dealing with credit ratings here; the data parameters are significantly wider and the stakes so much higher. To assume otherwise is naive.

No rating methodology can encompass all the viewpoints of what is ‘right’ and ‘wrong’; it merely reflects an output based on what an agency determines is material.

And it is because what is material is de facto subjective that we are seeing discrepancies in scores (and methodologies) between agencies that have unsettled so many investors (see also table below). Even if you applied Taparia’s proposed model, the methodology would still be based heavily on subjective judgements. What constitutes being “directly harmed”, for example?

To be blunt, seeing total alignment between agencies would be far more unnerving, implying complete agreement on materiality. The world’s superpowers have yet to find consensus on how to reach net zero, so why would a mere ESG analyst have all the answers?

That said, it is hardly surprising that some larger institutions have chosen to develop their own ESG rating framework, as Capital Monitor has reported. To name just two examples: Japanese insurer Nippon Life’s Nissay Asset Management and ATP, Denmark’s biggest pension fund.

So unless allocators are prepared to scrutinise every security they own and match raw corporate numbers against their own ESG policies, then some form of third-party scoring or rating must form part of the investment decision-making process. Life would otherwise be too complicated for most asset owners who lack the resources to go it alone. What matters is how much weight investors apportion to the ratings they use.

Moral compass

It could be argued that an allocator should value more highly ESG ratings methodologies that more closely match its own policies. Something to consider is whether an investor would have the courage to refuse to invest in products benchmarked to indices that do not align with its own approach.

Moreover, where there is an information vacuum or questionable rating outcomes, surely investors should seek proactive dialogue with rating agencies? With the huge combined influence that asset owners have on our future, working with rating providers to establish methodologies that fit best with their policy obligations would surely drive better outcomes than relying purely on market forces.

As one senior ESG ratings executive tells Capital Monitor on condition of anonymity: “We’ve been covering ESG for some time, but the challenge is huge. The amount of data available is vast but also inconsistent and non-standardised. We are all coming to terms with how we define material for all aspects of the E and the S in ESG.”

In fact, the fundamental problems raised in Taparia’s article may be even more simple than even he may care to admit: none of us are really sure what we mean by ESG. Asset owners should perhaps accept greater responsibility for this fact than most do.

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