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. We’re still putting the fundamentals together. The ESG ratings game is at an even earlier stage, having shifted into high gear only in the last couple of years. Mutual learning is possible and advisable.
As they go about what I call primary sense-making, confusion within the raters’ ranks is understandable. What Sikochi and Serafeim more 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 this year, but tensions clearly remain.) More worrying is Sikochi and Serafeim’s finding that increased ESG disclosure appears to increase the level of disagreement between rating agencies on performance. That could be funny but, with trillions of global investment dollars being directed by these methodologies, it’s not.
Fortunately, 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 ESG’s links to business performance and prospects for quite a long 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 take 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; while the weather had been unusual, 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 the ESG edge. Currently, ESG raters measure only a small fraction of this potential and this is a problem.
Let’s continue with the 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 its value at the ESG edge. ESG risk goes down; ESG ratings go up.
- As familiarity dawns at the edge, the bank 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’ very narrow selection of social impact drivers. If you’re Discovery Bank, and your ESG innovation lies in increasing financial health through behaviour change, your ratings stay put. Oops. ESG risks may be fairly standard across a sector; but ESG opportunities are infinite in the face of human ingenuity. (Disclosure: Incite has a long-standing strategic relationship with Discovery. The financial services company used in the example is fictitious.)
For obvious reasons, ESG rating methodologies do better on standardisation. And herein lies 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 the edge.
Every company’s edge is unique, so companies take different paths to high performance. As tech innovations in energy, transport, communications and food continue to disrupt every sector, sustainability performance should increasingly align with financial performance and prospects as long as we measure it effectively. Drawing on three decades of exploration with many companies and practitioners, we think sustainability performance can be tracked fairly effectively by two key factors: an organisation’s range of activity (what they do at the ESG edge) and maturity (how they do it).
Current ratings cover the organisation’s response to ESG risk fairly well and their response to ESG opportunity not so well. Most profit-led ESG innovations will slip the net, as may large-scale collaborations that address systemic risk to the broader market ecosystem. At this stage, ESG ratings methodologies also lean heavily on the existence of policies and programmes and appear to be limited when it comes to assessing the maturity of those policies and programmes.
So, as I mentioned, ESG rating methodologies are going to shift. It makes sense to up your ratings by ticking the various boxes, but companies confuse this with a strategic response to ESG at their peril.