The rise of the raters has boosted interest in sustainability performance. The sustainability field is at an early stage of formation – barely three decades old.  The fundamentals are coming together slowly. The ESG ratings game is at an even earlier stage, having shifted into high gear in the last couple of years. Mutual learning is advisable.

As raters make sense of the Zone, confusion within their ranks is understandable. What Sikochi and Serafeim kindly call the ‘muddiness factor’ also gives rise to some funny situations. One has been dubbed the ‘Tesla Conundrum’: MSCI gave Tesla a high ESG score based on their contribution to transformative transport solutions while FTSE Russell scored them poorly based on governance. (Tesla narrowly made it onto the S&P500 ESG Index in May 2021, but tensions clearly remain.) More worrying is Sikochi and Serafeim’s finding that more ESG disclosure seems to be increasing the level of disagreement between rating agencies on performance. That could be funny but, with trillions of global investment dollars being channelled by these methodologies, it’s not.

Happily, with a $30 trillion sustainable investment market, raters have ample motivation and resources – financial, human and digital – to advance their methodologies. Expect change to be a constant. Unless they find a way through the muddiness, ESG ratings risk becoming a bad signal in what US-based think tank RethinkX calls the decade of disruption. This is one reason that proprietary methodologies – and divergent scores – is likely to give way to increased regulation, resulting in what my friend Phil Barttram calls a ‘quick and nasty fallout’ in the ratings market.

In the meantime, sustainability practitioners have been exploring links between sustainability, business performance and prospects for quite some time. Carol Adams and Subhash Abhayawansa make this point in their blog on ‘harmonisation’ of sustainability reporting. A quick glance across the field shows sustainability frameworks aplenty, but less convergence on what is meant by maturity and performance.

Let’s imagine an example.

• Five years ago, a financial services institution was convinced that climate change was not material to its business because it had a low carbon footprint.
• Two years later, it decided that climate change was material to its investments in coal-fired power stations. Climate change made it onto the risk register.
• When their institutional investors started screening and tilting their portfolios for climate risk late last year, climate change shot into the top five risks impacting the company’s access to capital and cost of debt.

Its operations had not changed; the climate had not changed that much either. Perspectives had changed. An organisation’s ability to track and respond to a multitude of diverse signals determines its potential – practices, performance and prospects – at their intersect with ESG issues. Currently, ESG raters measure only a small fraction of this potential.

Let’s continue with our imaginary example.

• The bank responds to its awakening by investing more effort into identifying its ESG risks. It reviews its portfolios, decreasing its exposure to carbon. It terminates paper statements, greens it buildings, uploads policies on data privacy and even tries to screen its suppliers for ESG risk. It is developing the ability to protect value at its intersect with society and environment (‘the Zone’). ESG risk goes down; ESG ratings go up.
• As the bank becomes more familiar with this intersect, it realises that its emerging market drive is part of ESG too! When reviewing the carbon exposure of its investment portfolio, the team discovers new opportunities in financing green infrastructure. This informs an adjacent innovation opportunity, leading to transition loans for small businesses seeking to enhance their ESG credentials… and the bank develops its second fundamental capability at the ESG edge: value creation. Measurable financial value and positive ESG impact go up; ESG ratings increase too…

That is, assuming the bank’s profit-led ESG initiatives align with the raters’ weighting of social impact drivers. If you’re Discovery Bank, and your ESG innovation lies in increasing financial health through behaviour change, your ratings may well stay put. Oops. ESG risks may be fairly standard across a sector; but ESG opportunities are infinite in the face of human ingenuity.

ESG ratings are benchmarks and are based on standardisation. Hence the Tesla conundrum. Investors want to invest in innovators like Tesla and Discovery, but these potential ESG disruptors may slip through the raters’ net. ESG ratings are almost entirely focused on whether companies protect value – not on their ability to create or enable value at their ESG intersect.

Unless they find a digital way around this, companies should expect more active engagement from rating agencies in the future.

Banner pic cropped from a photo by Afif Kusuma on Unsplash