Companies and ESG raters have developed an interesting – if not adversarial – relationship since ESG ratings became mainstream a few years ago. The ratings systems evolved rapidly and imperfectly, while companies struggled to understand the basics of black-box ESG scoring systems and tried keep up. Significant differences in what some estimate as over 600 different ratings methodologies (which are almost all proprietary and secret) led some companies to throw their hands up in frustration and essentially ignore their ESG ratings. A study from the Columbia Law School examined how companies tend to respond to changes in one ESG rating methodology.
“Sustainalytics’ ratings are weighted sums, meaning they reflect a combination of raw scores and weights. A firm’s overall ESG rating reflects a weighted sum of E, S, and G scores. Each of the E, S, and G scores, in turn, reflects a weighted sum of dozens of underlying criteria scores. Our basic approach tests whether, and over what time horizon, firms improve their raw criteria scores in response when Sustainalytics places greater weight on a given underlying criterion.
Our main finding is that a 1 percentage point increase in weight for a given criterion is associated with an increase in raw score of about 14 percent of a typical change. This response occurs in the same month as the change in criterion weight.”
These results are interesting, but reflect complexities. For instance, it initially appears that this is a result of “firms … legitimately and nimbly adjust[ing] their ESG behavior,” but the study found “no evidence of this effect.” The two most significant influences in responding to changes in ratings methodologies are:
- The nature of methodology changes: “We find the relation between criteria weights and raw scores is greatest among criteria designed to measure preparedness. Many of these criteria involve the drafting of policies on topics such as money laundering, conflict minerals, data privacy, and so forth.”
- Company involvement: “Overall, the results show how firms influence their ESG ratings when they participate in the rating process. We conclude that firms ‘manage’ their ESG ratings to appeal to ESG-focused stakeholders.
At least with Sustainalytics, companies may be able to improve their scores just by being more involved and communicative in the rating process. On the other hand, as pressure mounts for companies to aggressively move to implementing written policies, we may see a concurrent shift in rating methodologies from merely “the drafting of policies” to action.
If you aren’t already, subscribe to our complimentary ESG blog here: https://practicalesg.com/subscribe/ for daily updates delivered right to you.