In recent years, Environmental, Social, and Corporate Governance (ESG) issues have become increasingly important considerations in investment decision-making. Why? Because it these factors have the ability to provide an inclusive administrative picture of a firm and identify the financial risks that often lurk unforeseen within investment choices. The three central pillars of ESG act as metrics for a business’ sustainability, their investments’ success rates and their profitability. As well as helping to determine the short and long-term risks and returns of an investment venture, ESG metrics serve as a benchmark for companies to enhance their socio-economic impact. As a result, the number of businesses following ESG practices is on the rise, and consequently so is the volume of ESG data available. It is estimated that around $30 trillion of assets invested worldwide are in some way influenced by ESG data, having risen by 34% since 2016. However, ESG data is by no means foolproof.
The growing importance of ESG has led to the formation of independent organizations which access, gather, sort and analyse the ESG data of firms in order to assign ESG ratings. Such organizations are proving successful, saving managers and asset owners’ time and energy – beforehand, investors who chose to study the ESG patterns of a firm had to conduct extensive diligence themselves, which asked for substantial industry expertise and a flawless understanding of the latest accounting standards. However, as the world currently has more than 125 ESG data providers such as Bloomberg, Thomson Reuters, FTSE, MSCI, Sustainalytics, and Vigeo EIRIS. As well as data providers that offer comprehensive 360 degree information on ESG practices of companies, there are also some which specialise on specific ESG attributes in more detail. For example, S&P’s Trucost provides carbon and “brown revenue” data, GRESB details sustainability performance in real estate and ISS focuses on corporate governance, climate, and responsible investing solutions.
An Incomplete Picture
The surge in ESG data and rating reports can be partially attributed to the fact that approximately 80% of CEOs believe that showing a commitment to a societal purpose can help to make a company stand out and perform better, leading to more investment. However, as much as ESG is proving to be a crucial tool in making wise investment decisions, there are nonetheless loopholes which, for now, significantly limit its scope. Since ESG is an ever-evolving and relatively new concept, its reporting standards are very much still at an infancy stage and the accuracy and uniformity of ESG reports and ratings sometimes appear subjective and unreliable. In fact, recently researchers have observed a significant disagreement among the ESG ratings of five prominent agencies across the globe – KLD, Sustainalytics, Video-Eiris, Asset4, and RobecoSAM. This variance can be attributed to the lack of market infrastructure and unstable scoring methodologies which can only be resolved once a uniform system is installed. The variance in ratings observed by these companies can be classified into three broad categories: weight divergence, scope divergence, and measurement divergence.
Weight divergence is observed when varying degrees of importance are assigned to different attributes which affect the ESG rating of a company. For example, one agency may value human rights more than the impact of lobbying, whereas another may value the latter more – subjectivity lies at the core of weight divergence. Scope divergence can occur when there is a difference in the set of categories analysed and computed to aggregate the ESG rating of companies. To illustrate this, one agency may consider greenhouse gas emissions, human rights, employee turnover, and corporate lobbying while another ESG data provider may choose to exclude lobbying and therefore skew its overall ESG rating of companies.
Finally, measurement divergence occurs when different indicators are used to measure the same attribute. For example, if a firm’s employee satisfaction is being evaluated, one ESG data provider might measure it via the employee rate and another may measure it regarding average salaries – it is this disparity in the choice of indicators which leads to sometimes very different ESG ratings between the various providers. Moreover, the reliability of ESG ratings remains vulnerable to biases of benchmarking. Since ESG is a metric of a company’s performance, the best-performing companies benefit more and poor-performing firms are assigned low ratings even if their current strategy is inclusive and they are headed in the right direction. This leaves large gaps in both ESG data and the evaluation process which only servers to reduce its credibility and value. As a result, the investor may be confused by contrasting reports and ratings by different agencies, drowning in extensive, illegible data.
A Bright Future for ESG
Fortunately, such problems are beginning to be addressed as a number of corrective measures are being adopted to eliminate the inconsistencies in reporting standards and ratings. The Sustainability Accounting Standards Board (SASB) is regularly updating their accounting guidelines in order to make ESG investing easier for managers and asset holders to understand while also improving the reliability of ESG data. Last year, SASB released 77 industry-specific accounting standards in order to help investors comprehend that companies’ financial performances can be affected by material sustainability issues. In addition to that, SASB and Global Reporting Initiative are continuously amplifying the amount of ESG information available in order to maximise the accuracy and comprehensiveness of reports and ratings. Moreover, companies such as Bloomberg are taking action to solve the issue of subjectivity of third-party organisations and analysts by transforming their methodologies in order to improve transparency and objectivity and to present high-quality ESG data to better inform investors in their decision-making processes. All in all, it may be a while before ESG is entirely standardized, but measures adopted in the past few years have certainly made ESG data more accurate and informative, and with more and more interest in ESG shown by investors, the pace of the reformation and perfection of ESG is only set to increase for the better.