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ESG Scoring Is Failing: Time For Improvement

Forbes Finance Council

George L. Strobel II co-founded Monarch Private Capital and serves as Managing Director of Credit Placements.

Environmental, social responsibility and good governance (“ESG”) standards for business conduct continue to rise in importance as a result of the economic chaos and human suffering caused by the Covid-19 pandemic. While companies are developing more comprehensive criteria, the standards are far from consistent. The reasons for the inconsistencies are numerous, but of greatest concern is the bias of ratings and the lack of public disclosure about the criteria and standards used in making those ratings.

Consequently, unlike financial information reporting, which has relatively standardized, disseminated and objective criteria, the information provided to ratings agencies varies widely by company and lacks verifiability. Even worse, the basis used for evaluating this information is secretly maintained and lacks peer or public review. The result is that the investing public is provided ratings scorecards that are at best inconsistent, subjective and nonverifiable. At worst, the ratings mislead the investing public. The SEC has made note of these failings in its investigation of purported “ESG” focused funds.

One positive outcome of the pandemic is the increased focus on social and governance factors.

Given the desire for more balanced ESG reporting, now should also be the time for the generation of a more functional ESG rating framework. That requires the adoption of objective standards among ratings agencies. By implication, that means subjective criteria and evaluations must play a reduced role in the final ratings report. The objective is for the public to have access to the standardized ESG reports, the outcomes of which are not dependent on the firm preparing the report. The goal would be to move far closer to what investors receive in the financial reporting world where the results of a financial audit are not dependent on whether it is prepared by a global auditing firm. The same cannot be said for today’s ESG reporting.

So what kind of objective standards should be used by ratings agencies?

We need objective criteria that can be verified by third parties. A significant portion of the scoring should be expressed in numbers. Numeric computations allow for meaningful comparisons between companies and industries. However, numeric results can lend themselves to false conclusions. For example, year-over-year reductions in carbon dioxide emissions by a global company could dwarf those of a much smaller local company. But the smaller local company might be carbon neutral and the global company nowhere near carbon neutrality.

To make meaningful comparisons between companies of disparate sizes and locations, the relevant criteria must be common to all companies: revenues, profits, units sold or produced, and number of employees. So the results, as an example, should be stated in terms of carbon dioxide reduction per units made, revenues, profits and number of employees. The denominators are all carefully tallied by financial accountants already and can be used as the basis for comparisons between companies, both large and small, within and between industries.

Meaningful ratings then need to be based on these objective criteria being examined in the context of others in your industry or even broader. For example, an auto manufacturer would compare its score per employee, per car made and per dollar of revenue with other auto manufacturers around the world to ascertain its industry ranking. Maybe it is in the top 10% for two items and the top 50% for a third criterion. The average would be a scoring of 23.33%. Such scoring can now be used as a comparison with other auto manufacturers. 

Should a subjective component be assimilated?

There should be a subjective component, but it should not have more than a 10% or 20% weighting, which would need to be consistent between all ratings evaluators. For example, maybe there is a mandatory ESG subsidy in one country and not in another. Or maybe a company has old technology and is investing heavily to catch up with cleaner technology. Those kinds of corporate initiatives deserve recognition. But clearly, the objective numbers must be made available for comparisons and should largely determine the ultimate ESG rating.

Likewise, it would seem that the subjective component of a rating should focus on identifying a company’s potential ESG risk. Is the clothing supply chain sourced in countries known for poor worker conditions? What testing is underway to ensure workers’ conditions are humane and child labor is not involved? Are factories with dangerous chemicals properly safeguarded, or are there risks of another Bhopal disaster? The presence of some of these risks is inherent in the nature of the business being conducted. Nevertheless, how those risks are assessed and addressed by specific companies can be illuminating. The public believes ESG ratings will help them be aware of the presence or absence of these risks in specific companies. In fact, today’s ratings largely ignore serious consideration of these factors as the ratings agencies pander to their corporate clients to curry further business.

What is required to make this happen?

While Covid-19 has shed light on the importance of a business’s response to ESG, the standards are still lacking transparency and consistency. There are several industry associations, such as the American Council on Renewable Energy (ACORE), that advocate for collaboration and attempt to unify finance, policy and technology to accelerate the transition to a renewable energy economy and providing more objective standards. Once ESG ratings agencies adopt a set of scoring criteria within each prong of ESG that can be measured and quantified, ESG ratings will significantly improve in their trustworthiness and utility to the public as well as enhance public acceptance of their findings.


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