ESG ratings have been the subject of controversy for some time. Notorious for their inconsistency across raters, opaque proprietary methodologies, and questionable performance indicators, ESG ratings have been thoroughly criticized on multiple fronts. However, that hasn’t stopped investors and other industry participants from using them. Recently, international law firm Mintz published a memo explaining ESG ratings and their common pitfalls and critiques. There was one novel concept that stuck out to me in this memo – the idea of ESG ratings creating litigation risks:
“Companies using ESG ratings products could encounter litigation risk, whether from public or private plaintiffs. Under the Biden Administration, several federal agencies have launched investigations to monitor companies’ ESG compliance. These actions have primarily targeted inconsistencies between companies’ ESG-related policies and conduct, on the one hand, and public disclosures on the other, but such enforcement activity could readily extend to the use of ESG ratings.”
This could manifest in several ways, such as:
- Companies that use positive ESG scores in their advertising. Hypothetically a company could tout their ESG credentials by pointing consumers to a positive ESG score received from a rater. However, there may be a disconnect between what a positive ESG score means and what a reasonable consumer would expect an ESG score to mean, thus potentially resulting in a misleading statement and greenwashing litigation.
- It could create another risky scenario for sustainable finance. A fund could market itself as being ESG-friendly or promoting ESG values using ESG ratings as part of the fund’s selection methodology for its portfolio. In this case, if the ESG rating doesn’t accurately reflect the ESG reality of the portfolio companies, then that could potentially translate to a misleading statement on the part of the financial institution and open them up to litigation risks from customers or regulators.
ESG ratings will continue to exist. Rated companies cannot control how third parties use their data and how others rely on that data, but companies can protect themselves by being careful in how they message around their own ESG scores.
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