ESG ratings and scores are fraught with credibility issues. This stems in part from the opaque nature of ratings methodologies. Most ESG ratings are proprietary black boxes, meaning that the public, researchers, and regulators, don’t know exactly how scores are calculated. However, through analyzing trends in ratings across companies, researchers found data that points to fundamental flaws in methodologies. One such flaw was written about recently by the SAFE Finance Blog:
“An intriguing pattern emerges, the Environmental pillar exhibits high correlation with the ESG pillar across all the rating agencies, indicating its significant role in explaining the cumulative ESG rating and highlighting the remarkable consistency of its influence across diverse raters. This high degree of correlation diminishes for the Social and Governance pillars, respectively, pointing to their lesser explanatory role in the aggregate ESG score. Thus, it appears that improving environmental practices is the most crucial aspect for firms aiming to enhance their overall ESG ratings. A first lesson emerges: If a company is good in E, it will likely be good in ESG.”
Granted, one could argue this isn’t new news. But the disproportionate weight given to the E pillar of ESG and its bleed-over into how raters assess the S and G pillars is (still) cause for concern. Companies with high ESG scores can still manifest significant social and governance risks – like Silicon Valley Bank (SVB). SVB’s ESG score was high even though SVB had no chief risk officer in the year prior to its collapse. This was a clear failing of SVB’s governance which should have been reflected in its ESG ratings, but it was overlooked possibly because of the company’s environmental commitments. Tesla is a perennial example of how high E ratings tend to be seen as more important than its corporate governance increasingly under fire because of the behavior of its mercurial (some may say bombastic, reactive and pot-smoking) CEO.
However, as the article mentions, new ESG rating regulations in the EU may soon shine a light on these methodologies and bring raters under the authority of the ESMA. Hopefully, this will result in stronger practices at ESG ratings firms and allow us to place more confidence in scores.
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