Individual investors who entrust their money to funds espousing environmental, social and governance principles may — unwittingly — be helping finance companies that “make climate change worse, not better”.
So runs the claim of US car company Tesla, at least. The electric vehicle giant recently used its 144-page annual Impact Report to slam the ESG rating industry. Among Tesla’s complaints were high scores for its “gas-guzzler” rivals and “unrealistic assumptions” about their carbon emissions.
While sour grapes and competitive rivalry may partly explain this broadside, Tesla is far from being the first to express frustration about the methodologies used by ESG analysts.
For example, in a damning study published last year, researchers at MIT’s Sloan School of Management and London Business School highlighted big discrepancies in ESG measurements, persistent data quality problems, and problems in assessing company ratings against financial performance.
Florian Berg, a research fellow at MIT and co-author of the paper, concedes that the complexity and the breadth of issues that fall within the remit of ESG defy simple analysis — and says a degree of variance is to be expected.
A lack of robust, publicly available information is also problematic, he notes. To make up for data gaps, ESG firms typically turn to industry averages. But, while that may make the maths neat, the danger is that poor performers get away with becoming “free riders”.
Beyond these technical shortfalls, Berg also identifies an overarching flaw in today’s evolving ESG assessment market: namely, a lack of transparency around how final ratings are arrived at.
The methodologies employed by ESG data providers remain “very much a black box”, he says. “They might give you the name of the indicators they use and, perhaps, the weights of those indicators, but I don’t know any that clearly explain how these indicators are created or what data go into them.”
Criticism of ESG scoring systems for failing to show their workings clearly is widespread.
In light of such concerns, the European Securities and Markets Authority is currently in the initial stages of a public consultation on the ESG indicators used by large rating providers.
Laurent Babikian, joint global director of capital markets at CDP, an environmental disclosure organisation, is one of those who deride the “artistic way” in which ESG scores are presently calculated.
“There is clear regulation in place for credit rating agencies but for ESG rating providers or ESG data providers there is no regulation,” he says.
Any such regulation would need to address a fundamental philosophical breach between ESG rankings that measure solely the financial dangers of social and environmental risks and those that assess the positive or negative impacts of a business’s activities more broadly.
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At present, regulators remain divided on the route to take.
The US-based global financial reporting body IFRS appears to favour the former “single materiality” position, while the European Commission leans toward the second, wider, “double materiality” approach.
For their part, ESG analysts are wary about one winning out over the other. The idea of a single standardised approach to sustainable ratings would undermine the flexibility and nuance currently built into the system, they argue.
Where critics see inconsistency and unexplained variance, large ESG firms point to tailored advice and insight for individual client interests.
“With ESG, there is a diversity of opinion in the marketplace — and that’s fine,” says Richard Mattison, president of intelligence provider S&P Global Sustainable1.
“If you think about standard financial information, like earnings estimates, for example, they do differ in their opinions, and they differ in the approaches they use to come to those opinions,” he points out.
Such a line of argument comes with the “major caveat” that the users of such opinions are clear on the assumptions and preferences that lie behind them — something Mattison insists that S&P Global Sustainable1 reveals “with great transparency”.
In a similar vein, investment research firm MSCI is wary about a single standardised approach to ESG ratings, although it says it welcomes the development of voluntary principles of conduct for the industry.
Such principles should make provision for “transparency and consistent application of rating methodologies”, says Neil Acres, MSCI’s global head of government and regulatory affairs.
As the regulation debates rumble on, developments in digital technology may offer a partial response to the clamour for transparency in ESG markets.
Growing market demand for information about company performance and risks arising from climate and other non-financial issues has prompted a host of fintech firms to enter the market in recent years.
Many act as data aggregators, hoovering up public and private data sets that they then provide to investors through easy-to-access, customisable digital platforms.
Free of any methodological filtering, these platforms offer a lower-cost means of mapping raw ESG data against the criteria of specific funds and investment strategies, says Ángel Agudo, vice-president of product at Clarity AI, an ESG data firm.
The New York-based start-up uses machine learning to categorise data on 30,000 companies and 135,000 funds, plus 375 countries and local governments.
Having an overall score that can help an investor classify companies is useful up to a point, says Agudo. But, he adds: “What ESG investors really want is to understand companies’ individual characteristics and then weigh these as they see fit.”