Research

ESG ratings are dead, long live ESG ratings!

Alexander Sassen

Research fellow in Finance and ESG

With EU ESG regulations (like the CSRD, Corporate Sustainability Reporting Directive) coming into effect for more and more companies in the next few years, a wealth of data on Environment, Social and Governance factors will become available. One of the intended effects of CSRD is that it provides all stakeholders a complete picture on ESG factors and the targets that are set by each individual company reporting under the CSRD. This will allow the financial sector governed by its own EU ESG regulation (SFDR, Sustainable Finance Disclosure Regulation), to make more sustainable investment decisions.

The importance of ESG ratings in investment decisions

In this context, rating a company’s ESG profile is an important activity, as it allows financial market participants (banks, pension funds, insurance companies et cetera) to determine how sustainable a possible investment and/or company is. However, as most financial market participants do not have the time and resources to do an ESG due diligence on each and every (potential) investment/company themselves, they will have to rely heavily on ESG rating agencies.

Controversy surrounding ESG ratings

But ESG ratings and the agencies providing these are not without controversy; they have come under fire, as different rating agencies have different ESG ratings on the same company; sometimes the ESG rating of one company by two different rating agencies come to diametrically opposed results! In other cases, the ESG rating on some companies made no sense to the public. This has elicited calls for, amongst other,

We need this newly developed feature here, where you directly see who is the author. Do you remember the latest update together with DN?
More regulatory oversight of ESG ratings agencies
The creation of an EU ratings agency,
The prosecution of firms that are greenwashing (making false claims about one’s sustainability profile)
The abolishment of ESG regulations altogether!

So, are ESG ratings useless? As always, the devil is in the details

Why has sentiment towards ESG ratings soured?

There are several, often overlapping, reasons why the mood soured in relation to ESG ratings. The four that will be discussed in this article are

Differences in methodology
Bad data/lack of data
Restatements by rating agencies
Wrong interpretation and use of ESG ratings by stakeholders.

1 Differences in methodology

The most important reason why ESG ratings have become so controversial revolves around differences in the methodology used by the rating agencies.

Relative versus absolute ESG ratings

Some rating agencies focus more on a relative intra sector ranking instead of coming to an absolute verdict. So, for example, within a very polluting sector, one company can have a much better ecological profile than its competitors and thus will get a high rating on the E of ESG (i.e. the company outperforms its peers on E factors). The rating itself then does not indicate if the company is deemed sustainable in the absolute sense, but in a relative sense. It indicates if the company is the most sustainable (or in this case the least ecologically unsustainable) company within its sector. If the company then also does a good job on S and G factors, the total ESG rating will be high. Then indeed, an oil major can get a higher ESG rating than an electric car manufacturer. This also explains why some rating agencies have different ESG ratings on the same company; as one rating agency might just rate on absolute terms (is the company sustainable), while another rates on relative terms (is the company sustainable compared to its peers).

Ordinal scale

The differences in methodology do not end there. One needs to keep in mind that most of the ESG factors are ordinal; i.e. one can claim that a certain profile on an ESG factor is better or worse, but quantifying it exactly (“it is twice as good”, “it has increased by 10%) is impossible; judgement needs to be applied making it subjective rather than objective. For example, within ESG (the G to be exact) it is deemed favorable if the supervisory and executive boards are diverse. So, if a company’s board expands by adding a female or a person from the LGBTQIA+ to increase the diversity of its board, it is deemed as an improvement in Governance. But how much better has it become? And if another such person is added to the board, how much better is that? And should the diversity in executive board weigh more heavily than in supervisory board? Rating agencies therefore apply certain weightings to these matters, but the weighting given and the weighting methodology often differ between rating agencies. As a company is rated on a very long list of E, S and G factors, it is only logical that different rating agencies come to different ratings on the same company.

Double materiality

Another difference in methodology concerns the double materiality principle. Simply said, the EU ESG regulations stipulate that companies falling under the CDRD regulations need to perform a double materiality test to determine on which of the voluntary ESG factors they need to report (next to the mandatory ones). This roughly means that they should not only report on the material impact they have/might have on the world re ESG factors, but also if ESG factors do and/or might materially affect their business financially.

Not all rating agencies apply this principle in their rating methodology. This means that, yet again, ESG ratings of the same company might differ between rating agencies due to the inclusion or exclusion of the double materiality principle.

Recently, certain concerns have been aired that the rapid consolidation in the ESG rating sector has put the biggest ESG ratings brands (which have their origin in Europe) in the hands of the big US rating companies like Bloomberg and Moody’s. As the US ESG focus is different from the one in the EU and the fact that in the US the double materiality concept is not embedded into ESG regulations, the fear is that this might entice ESG ratings agencies, that did include double materiality in their methodology, to drop the concept from their methodology going forward. While this would at least lead to alignment between rating agencies on this particular point, it does lead to a misalignment of ESG ratings with the ESG goals set by the EU, which in itself will not help dispel the negative sentiment around ESG ratings.

Scope 3 and scope 4 emissions

Other differences in methodology also revolve around differences in how, or even if, to take scope 3 and scope 4 emissions into account. The emission of greenhouse gasses (GHG) that are emitted by a company (scope 1), by for example suppliers of lease cars or electricity to the company (scope 2), by the rest of the value chain (scope 3) and the GHG emissions that have been prevented because of the services/products a company delivers/produces (scope 4, which is not an official concept yet), are handled differently by different rating agencies. This also leads to different ESG ratings for the same company.

2 Bad data

Even if all the rating agencies would use the same methodology, the lack of data and/or the bad data quality, will lead to ESG ratings that are off the mark.

Challenges for smaller companies

While there seems to be alignment between rating agencies in how to treat a lack of data (on a specific ESG data point that is missing, a zero score is assigned), it does mean that companies that are not as advanced in the ESG factor data gathering and processing, will receive lower ESG ratings than their more advanced peers. This difference is especially to be expected between large and small companies that fall under the CSRD framework; the larger firms have more resources and bigger value chain partners, than the smaller companies, so in most cases they will have more data on ESG factors than their smaller peers. This might lead ESG ratings on some smaller companies to be off the mark (underestimating the ESG profile), leading to an artificially stark contrast with their larger peers. If investment flows are purely based on ESG ratings, this might have far reaching consequences, which will not help the sentiment on ESG and ESG ratings.

The bad quality of data and/or the patchiness in available ESG data, also hurts the accuracy of ESG ratings. This is exacerbated by the fact that, again, larger companies are ahead of smaller companies.

Impact CSRD’s phased rollout

This is in part due to the phased rollout of CSRD, with larger companies having to comply earlier than smaller companies. It is easy to see that this leads to less accurate ratings on the smaller companies, thus further throwing into doubt ESG ratings in general.

3 Restatements and incomparability of ESG ratings

When more data becomes available and/or methodologies used by the ratings agencies evolve, ESG ratings are either restated, or, if that is not the case, show big moves (either up or down) compared to historic ESG ratings, with financial market participants potentially finding out they divested or invested based on faulty ESG ratings.

4 Misinterpretation and misuse of ESG ratings

All put together, it is no surprise that stakeholders are confused about ESG ratings. Furthermore, due to this confusion and misunderstanding, stakeholders often misuse and or misinterpret ESG ratings. This, for the most part, explains the negative sentiment around ESG ratings.

Steps taken by the EU

The EU is not blind to some of these problems and has already mandated that rating agencies need to be more transparent about their methodology, but has not mandated a universal methodology. This will address some of the confusion, especially for the insiders, but will fall short of taking away all controversy around ESG ratings; some confusion will remain as, at face value, there will still be different ESG verdicts on the same company and or inexplicably high or low ESG ratings on some companies. Therefore, the less informed professionals and the general public might still question the quality (and thus usability) of ESG ratings.

The Road ahead: educating stakeholders

As time progresses and more companies have to report under the CSRD, more and better quality data will become available. This should help resolve, in part, the problem surrounding ESG data. But this will for the most part only apply to the EU arena and not necessarily the global arena, where ESG regulations are different, which might still prolong discrepancies in ESG ratings.

So, while time and some of the steps taken by EU regulators will certainly help reduce negative sentiment around ESG ratings, completely dispelling it, it will not.

For that to happen, ESG regulations and ESG rating methodologies should converge. While this will certainly happen to some degree, it will never converge a 100 percent. So discrepancies will remain. It is therefore key to inform and educate people, starting with business leaders, the press, politicians, regulators and educators about the intricacies of ESG ratings and how to properly interpret and use them. Only then, ESG ratings can serve their intended purpose.

About Alexander Sassen

Alexander Sassen holds a Bachelor degree in International Relations, a Master in International Business, and an MBA. After spending over a decade as an equity analyst and stockbroker, Alexander founded his own research company, specialising in finance and ESG (Environmental, Social, and Governance) regulations. In early 2019, he joined Hotelschool The Hague to share his expertise in finance with aspiring hospitality leaders.

As the owner of Sassen Research & Consultancy and co-owner of Conifer Advisory Services (ESG), Alexander is a recognised expert in ESG regulations and Finance. At Hotelschool The Hague, ESG is a key component of the curriculum, equipping students to lead in hospitality and other sectors where sustainability is vital. Whether managing global businesses or starting entrepreneurial ventures, students are well prepared to integrate ESG into strategic and operational decisions.