Raise your hand if you have never heard of ESG ratings. At least since the introduction of environmental, social and governance factors into corporate financial analysis was popularized in 2006 by the United Nations Principles for Responsible Investment report.
Their notoriety in the international context has never stopped since. As a matter of fact, googling ESG is enough to index well over 800 million results and discover that the search frequency of the infamous acronym is now twice as high as it was in January 2021. Numbers that in fact may, however, mask a general sense of confusion, given that according to various estimates, there are now more than 600 ESG standards. As markets struggle to give an unambiguous signal, could it be time for simplification?
ESG ratings, increasingly prevalent but also increasingly lacking
As an evaluation methodology alongside the traditional credit risk profile, ESG ratings were created to make the environmental (E), social (S) and governance (G) performance of companies, issuers, funds, and countries visible to investors. At the same time, in addition to guiding investment decisions, the ratings serve as a litmus test for the rated companies and organizations themselves to verify their ability to address risks and opportunities in terms of sustainability.
The increasing focus of financial markets and the need for self-assessment are different sides of the same coin and have therefore prompted the proliferation of providers. MSCI, Morningstar, S&P, Moody's, or Refinitiv are, in fact, just a few of the best-known agencies, each, however, with its own metrics. After all, as the Rate the Raters 2023 report confirmed, today “finding investors who do not use ESG rating products is increasingly difficult.” Nearly 100% of investors surveyed by the researchers rely on this tool.
Despite high usage, however, placeholders and companies are frustrated by the shortcomings of the ratings. What would be of most concern are the “black box” methodologies (characterized by the inability to know their inner workings) and the questionable accuracy of the data. “52% of companies and 59% of investors have only moderate trust that ESG ratings accurately reflect ESG performance,” the report says.
Dissatisfaction then passes through another sign: investors are increasingly choosing to build ESG analysis and rating systems in-house, using raters only as data providers. A trend that could “create bias in ESG ratings.” How to reverse the trend then? The survey shows that more than half of investors and nearly half of companies want “greater consistency and comparability among rating methodologies” and “better quality and disclosure of methodology.”
Markets suggest an evolution
If it is true that ratings are crucial in incentivizing companies to act and highlight their ESG performance in investors' eyes, then it can be useful to look at the markets' response. After the record flows achieved during the Covid-19 pandemic, thanks in part to rising oil prices, in 2022 ESG investing began to lose appeal. A course reversed after two years only in the fourth quarter of 2023, though not in all markets. According to Morningstar, globally, ESG fund assets increased 8% in the fourth quarter to nearly 3 trillion dollars.
After months of outflows due to regulatory changes and a drop in subscriptions at the end of 2023, Europe remained the leader (3.3 billion dollars) in the fourth quarter; the opposite was true in the United States, where investors took out 5 billion dollars. In contrast, as for Asia (excluding Japan), total assets of ESG funds rose 5% quarter-on-quarter to 61 billion dollars. Mostly thanks to Taiwan-domiciled funds.
“My view on the current state of ESG investing globally? Let's take a look at the European Union, which is gearing up for the future and leading the process. Asia is really lagging behind in this space,” Carlo Chen-Delantar, Head of ESG at Gobi Partners, a pan-Asian venture capital firm present in 15 countries with 1.6 billion dollars in assets under management, comments to Renewable Matter. “I think in any industry, ESG is gaining a lot of traction. But ESG in general is not immune to hype or controversy. We continue to believe that ESG should be the future and should be incorporated into practices. For investors or a firm like ours, we think it is an integral part of the concept of responsible investing.”
A push for simplification
Before opening up to possible future scenarios, it is necessary to reiterate the basic need of the various players in the market: clarity. Regardless of how the question of whether and how to go about simplifying the more than 600 ESG rating standards is chosen to be unraveled, it is indeed clear that the ecosystem of non-financial reporting will be all the more robust (and thus attractive to capital and a promoter of best practices) the more consistent, reliable, and comparable information will be across agencies and geographies. Qualities emerged as early as 2020, when CDP, Climate Disclosure Standards Board (CDSB), Global Reporting Initiative (GRI), International Integrated Reporting Council (IIRC), and Sustainability Accounting Standards Board (SASB) signed a joint statement reaffirming their commitment to engage all stakeholders to achieve “a comprehensive and globally accepted corporate reporting system.”
However, this does not mean electing a single standard, but identifying the lowest common denominator in accordance with some kind of principle of neutrality. After all, this is the solution followed by the International Sustainability Standards Board (ISSB), a body established in 2021 during COP26 under the aegis of the IFRS Foundation, the same entity responsible for international financial reporting standards. But though the first two IFRS Sustainability Disclosure Standards on climate are in effect as of January 1, 2024, their adoption is still based on a voluntary regime. It all remains to be seen, in short.
An interesting point to dwell on, as pressure for harmonization could open new valves. “The ISSB focuses on the single materiality or ESG information that drives the valuation and is important to investors. This is also the focus of the Securities and Exchange Commission (SEC), the US federal regulator of stock markets, and so the mandates are consistent,” wrote Bhakti Mirchandani and Robert G. Eccles of Oxford University in February 2022 in Harvard Business Review.
However, the principle of double materiality is already entrenched in EU law. While single materiality requires companies to report on how ESG factors affect operations and financial performance (outside-in direction), double materiality also requires an assessment of impact on the environment and society (inside-out direction).
“The European Union's Corporate Sustainability Reporting Directive (CSRD) has a broader double materiality mandate,” Mirchandani and Eccles explain. This means that it “will cover information of interest to stakeholders, even if it is not of interest to investors. Bridging then emerges the concept of dynamic materiality. In this way, ESG issues that are not of interest to investors today can become relevant in the future.” Materiality thus becomes an ever-evolving process: what seems financially negligible today may in fact quickly become crucial to the business tomorrow. Not just clarity, then, but flexibility.
Decoupling the pillars of ESG?
“The whole combination into one score of these three very different factors never made sense,” Robert Jenkins, Global Head of Research, Investment & Wealth at LSEG, comments to Renewable Matter. According to Jenkins, one cannot incorporate materiality qualitatively within a single metric. “If a company has a great environmental balance sheet but a bad social or governance balance sheet, it ends up in the middle of the pack and vice versa. It is not possible to distinguish which of the two pillars is winning.”
What would be the solution, then? “Let's separate the pillars and get rid of the term ESG. Let's eliminate the idea of trying to combine them into one. Let's understand that their definition is very personal and that there are some underlying strands of analysis that we need to measure. And we will figure out how to measure them,” Jenkins explains. “That way investors can look at a dashboard with the different analyses regarding a company, fund, or ETF and say: yes, I like what it represents, it doesn't condemn fossil fuels, for example. Or: I'm investing in companies that are making a positive transition of their business and reducing their footprint. That way, you can choose what you like. I think we are moving down this path.”
The reasons for a split would be simultaneously supported by the need to ward off accusations of greenwashing and the increasing use of AI in the financial field. “Having worked in the field of ESG analysis for a long time, the biggest problem is the excessive amount of information. To really analyze whether a company is making an effective transition, whether it is doing it profitably, sustainably, and minimizing risk, it is important to combine traditional non-financial metrics with traditional profit-related metrics. There are several rules for figuring out how to bring these different data sets together and integrate them into a single metric. And by the way,” Jenkins concludes, “this process is different for every industry.”
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This article is also available in Italian / Questo articolo è disponibile anche in italiano
Photo: L.O.V.E. “Libertà. Odio. Vendetta. Eternità.” (Freedom. Hatred. Vengeance. Eternity.) also known as “Il Dito” (The Finger), a statue by Maurizio Cattelan (2010) located in front of Palazzo Mezzanotte, headquarters of the Milan Stock Exchange.