ESG ratings are an immature business

ESG ratings are an immature business, and it shows. Beneath their popularity is a business that is still only finding its feet.

They’re supposed to be a clear window into a company’s ESG performance, encompassing strategy, risk, and opportunity. But there are so many of them – each of which is measured differently; some attract more criticism than others. 

It’s a challenging business to find comfort in.

In September 2023, research published by Columbia University suggested that one of the biggest names in ESG ratings – MSCI – depended heavily, perhaps too heavily, on revenues from sales from index products (products specifically designed to reflect the performance of relevant standardised collections of securities) when calculating ratings. 

This, according to Joachim Klement – an investment strategist at Liberium – was indicative of an industry that was driven too much by questionable metrics and suffering in credibility. 

There may well be “monetary conflicts of interest at play,” he told the Times.

There’s no denying that ESG ratings are an immature business, and findings like this won’t help their cause. Compare them to credit ratings, as we can easily see the real problem:

The household-name agencies behind these ratings, like Moodys or Standard & Poors, have developed robust methodologies over decades, giving clear measurements that ESG agencies lack so far. 

For ESG, there are simply too many ratings, too many methodologies, variations in standard definitions and no clarity on each one’s authenticity.

Amid this white noise, we have countless corporate stakeholders, from regulators to consumers to investors, chanting for more focus on ESG and jumping to ratings as a key indicator of success or failure. 

How will that system work if the ratings themselves are seriously undercooked? Where is the sophistication?

It has a lot to do with greenwashing – the practice of making your products and services appear environmentally friendly through clever marketing in PR when, in reality, they’re not. 

To many, ESG ratings remain the new, shiny, and thorough method of measuring a company’s sustainability practices. But if these ratings vary widely in their inclusion of questionable metrics, many results could easily be interpreted as a form of greenwashing. 

Why wouldn’t they be?

Absolutely, yes; that’s the most urgent problem we need to tackle. ESG ratings could be a hugely beneficial tool in governance and investing; they’re just not at the standard they need to be at yet.

We need to see the ESG rating industry mature and fast. We need the current directionless system of questionable integrity to evolve into a well-respected global authority so that companies’ ESG efforts can be given the credit they deserve. 

This means:

1. A more standardised global system which will eliminate confusing discrepancies between different rating systems. 
2. A more hands-on approach from regulators to give more legal structure than today. 

Thankfully, there is already movement on point number two as governments work to take control of the ESG rating industry. 

Ministers in the UK government are now looking at the best way to regulate ratings. At the same time, the European Commission proposed has drafted rules in June targeting a permission-based system with minimum standards. 

Regulators are flexing their muscles, but as with any new proposals like these, it will take a lot of time to develop them. 

It means that, for now, we’re stuck in the same quagmire.

Any board that boasts about or relies on an ESG rating to please stakeholders should know how it’s calculated and the intricacies of source data. If you can’t explain your reasoning, you might be in trouble when the rating gets investor scrutiny, bad press or worse.

Take MSCI above; it’s a standard rating system based on ESG risk and opportunities, but commentators and mainstream media have thrown its integrity into doubt. 

Whether you agree with the criticism or not, if you rely on the metric, you will have to answer to worried stakeholders.