ESG ratings are an important part of how companies are evaluated on their ESG progress. Ratings are used by investors, regulators, and other stakeholders to conveniently asses a company’s ESG progress, however, the current ratings market is not without its flaws.
Recently, Financial Times published an article discussing the intricacies of the ESG rating ecosystem and proffers some advice on how the industry can advance quality ESG ratings. One major area for concern is the perceived conflict of interest present in many ratings firms. Raters with consulting arms may be conflicted since they are being paid by both investors which seek unbiased data and by companies looking to improve their scores.
The article also points out high variability among raters as an issue affecting rater credibility. There are problematic and acceptable reasons that two different ratings firms might give the same company vastly different scores. Problems arise when variability in score is the result of raters working from two separate data sets. The hope is that ESG disclosures will be standardized through mandates and streamlined frameworks which will give raters a uniform set of data to work from.
However, not all differences in ESG scores are problematic as the article points out:
One legitimate reason for differing ratings is their varying objectives. Some emphasise impact materiality, which assesses pollution based on its ecological harm. Others concentrate on financial materiality, whereby pollution is a concern only if it incurs costs for the company. This fundamental difference will obviously lead to different rating outcomes.
ESG ratings will hopefully become more reliable as regulations around company disclosures and ratings firms tighten. Quality ratings are invaluable for investors and other stakeholders looking to make decisions based on sustainability performance. However, until ratings achieve a higher degree of reliability ESG ratings should be taken with a grain of salt.