Finding Middle Ground with ESG Ratings: Scores Still Matter, But Approach Matters More
While critics continue to knock ESG ratings, they are still extremely relevant. Adopting a balanced approach to optimizing ESG scores allows companies to get the right credit for the right efforts.
Over the last few years, there has been a significant debate about the relevance of ESG ratings (also referred to as scores). Critics argue that investors have replaced ratings with their own proprietary assessments and the methodologies of ESG ratings agencies vary too greatly to make them reliable sources.
A lot of this pushback stems from the rating industry’s nearly decade-long heyday during which many companies fixated on ESG ratings as the indication of corporate responsibility, and, subsequently, the gateway to appealing to institutional investors. Multitudes of companies incessantly prioritized ESG efforts around anything and everything what would boost their scores, rather than what was most important to their organization.
ESG ratings are not obsolete, but they shouldn’t be the sole focus of sustainability programs, either. While overdoing the pursuit of better ESG ratings isn’t advisable, neither is ignoring the ratings completely, as some staunch critics suggest. As with most things, the right approach falls somewhere between the two extremes.
For corporate leaders looking for balance, here are a few considerations to keep in mind.
ESG ratings impact billions of dollars in funds
Estimates suggest that roughly $350B in assets under management sit with passive ESG funds. These funds rely on ESG indices to inform portfolio inclusion based on ESG ratings. For example, an index fund may include biotech companies with a top decile ESG rating or auto manufacturers with a strong social score. And these kind of passive ESG funds are much more prevalent than some companies realize. MSCI, for instance, boasts over 3,900 indices and Refinitiv offers an additional 630 of their own. These indices are important sources of investment in companies, and they help reduce volatility in the stock since passive funds are not actively buying and selling.
Further, many portfolio managers continue to say they look at ESG ratings as one of many inputs (not the input) when evaluating an investment opportunity. Even for portfolio managers not explicitly seeking ESG ratings, they’re difficult to avoid. Companies’ Sustainalytics scores appear on Morningstar; ratings appear on ISS and Glass Lewis proxy reports; Bloomberg terminals include proprietary ESG ratings; ISS and MSCI scores appear on FactSet; and there are many more examples. Clearly, it would be quite difficult for any investor to remain unaware of how a company scores in ESG, and corporate leaders simply can’t expect to fly under the radar if their scores are poor.
Suppliers and customers are actively looking at scores
Some discerning stakeholder groups, namely suppliers and customers, increasingly consider ESG performance when evaluating potential partners and making buying decisions. The COVID-19 pandemic accelerated the issue for businesses looking to improve the dependability, transparency, and responsibility of their supply chains. Before selecting a business partner, organizations want to better understand a range of practices spanning human rights, environmental impact, data security, and much more.
Some organizations leverage providers like EcoVadis to directly assess the practices of customers and suppliers. But this route is not feasible for most companies. Indeed, the Coca-Colas and Unilevers of the world can exert influence over suppliers, requiring them to complete questionnaires and assessments. But smaller businesses cannot. Instead, they turn to ESG ratings organizations that do the data aggregation themselves. Keep in mind that while many small businesses may not yet be at the point of cutting ties with suppliers or customers purely due to poor ESG scores, ESG ratings can absolutely tip the scales against businesses who are underperforming compared to their direct peers.
Good scores are very often good enough
In the early days of ESG ratings, many investors expected to see continuous improvement. As a result, a company finding itself in the bottom quartile might relentlessly channel efforts into making improvements year in and year out until it finally makes its way to the top quartile.
This approach has several pitfalls that have led many companies astray. For starters, not every company can be in the top quartile—there must be winners and losers. Secondly, most investors nowadays are more interested in avoiding the low performers than they are in finding the top performers.
Rather than viewing ESG as a never-ending competition to reach the pinnacle, draining time and resources along the way, companies can be comfortable with a B+ rating achieved by focusing on the most material issues for their businesses. No organization should feel inherently compelled to pursue an A+ solely for ratings purposes, particularly if the effort is not otherwise aligned with ESG or corporate strategy.
ESG ratings can and should be one part of a thoughtful ESG strategy
As with all things, moderation is the key here. Don’t ignore ESG ratings and risk alienating stakeholders who continue to consider them for a variety of valid reasons. But don’t put all the eggs in one basket by overemphasizing ratings above other priorities. A strategic, comprehensive approach to ESG rooted in materiality should be the starting point for every organization. Based on this foundation, companies can consider shaping relevant disclosures to address the topics that ESG ratings methodologies prioritize. Making this effort a part of the overall strategy can help organizations avoid poor scores that could exclude them from ESG indices or negatively impact relationships with important stakeholder groups.
Concerned about your ESG ratings or need help understanding how ratings fit into your ESG game plan? Connect with our ESG experts today. We offer proven approaches to remedy scores in the short-term along with strategic advice for a successful long-term ratings approach that fits your company’s objective and needs.