Given the importance of sustainability to current business models, it is no surprise that those measures which rate company performance on environmental, social and governance (ESG) issues have become highly influential.
But we now have scores of methods and providers. For my research, I investigated 218 different ESG initiatives and interviewed 45 asset owners, asset managers and companies in the Netherlands, the UK and Germany. I found that reporting fatigue at company level is a substantial cost that is often overlooked. What makes matters worse is the lack of convergence of ESG ratings and rankings.
Although this industry can be useful in bridging the gap between companies and investors, we do not need this many bridges. The benefits mentioned by practitioners can be obtained by a handful of ESG rating or ranking agencies, as opposed to hundreds of them.
Rating and ranking
The first attempts at an ESG rating can be traced back to 1969, when the Council on Economic Priorities was launched to track corporate and government behaviour.
Although the Council did want to start rating companies, the inherent subjectivity kept them from going through with it.
However, a little over a decade later, in 1983, the first rating agency was launched. EIRIS (now VIGEO-EIRIS) started out as a foundation to help churches and charities invest in line with their faith. Initially, their rating criteria were based merely on exclusion, but they expanded their offering a few years later. Kinder Lydenberg and Domini (KLD) and Jantzi Research (now Sustainalytics) followed suit in the beginning of the 1990s, and the rest is history.
The Rate the Raters initiative by SustAbility found that, out of 108 organisations, about 60% rely completely or partially on information submitted by companies. They may send questionnaires, ask for interviews or even visit them on site.
If you consider that there are currently at least 249 different products that rate, rank or index these companies, it is not difficult to imagine that this becomes burdensome. If 60% of those contact companies directly, this translates to 149 questionnaires and often opaque methods of assessment. Companies need a staff member who is at least half-time to full-time to respond to the many requests that come in. This is on top of the work they already put into their sustainability reporting, answering ESG-related investor enquiries and applications for ESG awards.
It must be noted that there are benefits to this, as the questions provide a helpful way of identifying improvement points. The DJSI (Dow Jones Sustainability Indices), for example, can be used as a benchmarking tool. Discussions with investors are often still dominated by short-term financial questions and do not provide companies with helpful ESG input.
Sustainability managers thus tend to use input from raters and rankings instead. This helps them to gauge external interest in their ESG efforts and to create a sense of urgency internally. This is useful, since top management is more likely to sign off sustainability initiatives if they know that there is external demand for it.
Lack of convergence
Digging a little deeper, one finds that there is a lack of convergence between ratings and rankings. They vary widely, conditional on the audience that they are looking to serve. The criteria that they consider often consist of hundreds of indicators, making the aggregate score a rather noisy proxy for ESG performance.
Making matters worse are the subjective weights allocated to the different dimensions of ESG. This obviously spreads confusion among practitioners. An example is Volkswagen being proclaimed industry leader, just before the diesel scandal erupted.
This raises the question of how much we can really tell from the way a company fills out the questionnaire that their rating is based on. Perhaps this questionnaire merely reflects the intentions of a company rather than its actions. Or, perhaps some companies have an advantage, because they have the resources to hire people who know how to tick the right boxes.
The lack of convergence is no surprise, given that they need to distinguish themselves from competitors. Moreover, this type of non-financial data is haunted by a lack of standards, consensus and understanding. Since we do not know what ESG really is, there are now (too) many intermediaries, with just as many opinions.
The ESG rating and ranking industry is widely used by investors. This means that a substantial amount of capital is allocated based on the judgement of these intermediaries.
Investors tend to screen hundreds of stocks on ESG performance. Quantitative metrics thus make this process more efficient. The number of stocks covered by an ESG rating therefore matters as well, since the investable universe needs to be sizeable. This is one of the reasons behind the popularity of rating agencies MSCI ESG and Sustainalytics.
Most investors rely on these scores in one way or another. More fundamental investors may use the narrative in the ESG rating reports to challenge their own viewpoint as opposed to the (subjective) scores.
Although this makes more sense given the credibility issue of the scores, this is not always feasible in practice for two reasons. First, the portfolio may be too large for this exercise. Second, ESG is not taught in many business schools. This means that investors (and asset owners alike) often lack the expertise to integrate non-financial information into their valuation models.
Outweighing the costs and benefits of the industry, it becomes clear that there are now too many ESG ratings and rankings. This causes confusion among practitioners, and reporting fatigue at company level. It is burdensome for companies to pour their ESG information into all the different standards that exist today.
However, the majority of companies continue to respond, because they are afraid that investors care about all available ESG information.
The truth is that the majority of investors do still care about ESG scores, but only about those they subscribe to. In most cases, this is Sustainalytics or MSCI ESG. Companies can thus filter out a substantial number of other initiatives and put their time and resources to better use.
It is important that investors are not only aware of the pitfalls of blindly relying on scores, but also of the reporting fatigue it causes. They should make sure that the chosen research provider is not relied upon unquestioningly, and that the methodology reflects their investor beliefs.
They should have a conversation with their portfolio companies about ESG and materiality. They should also discuss the issue with their clients to make sure that everyone is on the same page.
After all, using different providers may yield different results. This may cause hiccups in implementing a responsible investment strategy, which may then be abandoned as a result.
Stephanie Mooij is a researcher at the Smith School of Enterprise and the Environment, University of Oxford. Further details can be found in her paper: Mooij, S., 2017. “The ESG Rating and Ranking Industry: Vice or Virtue in the Adoption of Responsible Investment.” JEI, State of ESG Data and Metrics 8, 331–367.