by Daphne Biliouri-Grant

There is no question that environmental, social and governance (ESG) ratings are an important part of the implementation process of ESG considerations. ESG ratings have been established in order to measure how a company is perceived to be performing on a range of ESG issues both for internal reporting purposes, as well as for external considerations, such as requirements set up by investors or other stakeholders. Currently they are the numerical measurement used to quantify ESG data and are used by investors to determine a company’s ESG performance.

However, there has been substantial criticism about the methodologies that ESG rating providers utilise and the level of subjectivity on how companies are performing within the ESG space.

There are numerous issues that make the current ESG rating process extremely problematic, but I would like to highlight two of the most important ones -   a) lack of standardisation of ESG criteria and b) lack of quality data that are reliable and objective.

Due to the fact that every ESG rating provider uses a different set of criteria to assess a company’s ESG performance, it is difficult to determine which one is actually the most effective and provides a realistic assessment. The use of different sets of data means that there is not a uniform evaluation system in place, so the ESG performance of companies is inaccurate as they are not evaluated on the same basis.

In addition, the ESG data that are being collected and assessed are highly subjective due to the dependency on self-reporting which results in unreliable data being used. Overall, ESG rating providers collect and combine information on a company’s ESG performance through the company’s own disclosures (i.e. Sustainability or CSR reports), third-party reports (i.e assessments from NGOs), news pieces, and proprietary research through company questionnaires. This means that ESG ratings are calculated based on how a company’s ESG objectives are reported, rather than on how they are met, so there is a disjuncture between perception and reality.

Since ESG data are obtained from a variety of sources and different methodologies are applied, they are bound to diverge from one provider to another. As a result, investors make decisions based on incomplete or inaccurate information. There is unquestionably a growing demand for more consistency amongst all the rating agencies in terms of how they measure ESG considerations to ensure accuracy of information and verification from a reputable organisation. The independent review of sustainability practices will only enhance a company’s ESG efforts in terms of transparency and accountability and can optimise its efficiency.

On May 2020, the US Securities and Exchange Commission (SEC)’s investment committee decided to create an ESG disclosure framework for consistent and comparable information without the use of a third-party rating agency. The SEC announced that “the SEC is best-placed to set the framework for issuers to disclose material information upon which investors can rely to make investment and voting decisions.”

The ambiguity that surrounds ESG ratings was the main motivator for the committee’s decision. The SEC feels that the establishment of a standard framework could resolve the current confusion that exists around ESG implementation and ensure that the embedding of ESG considerations within a company can progress faster and more successfully.

Jay Clayton, the Chairman of the U.S. Securities and Exchange Commission (SEC), expressed his concerns about the efficiency of ESG ratings in May 2020 at the SEC’s Asset Management Advisory Committee meeting:

“I have not seen circumstances where combining an analysis of E, S, and G together, across a broad range of companies, for instance for a ‘rating’ or ‘score’, particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise”.

Therefore, within the current ESG landscape, the next big challenge is how to establish a framework of consistent and transparent reporting that allows the comparative assessment of companies’ ESG practices within their sector/industry.  As the landscape of ESG rating systems is still very much evolving, there is hope that the investment ecosystem can overcome such barriers, it can strengthen its influence, bringing more corporate practices in line with ESG principles. But there is still a long way to go before we can talk about a uniform ESG rating system that can accurately represent a company’s true ESG credentials.