ESG Ratings Are Bottom-Line Focused, but Have Broader Impacts

Sustainable investing has attracted its share of criticism lately. That’s to be expected when a new concept enters the mainstream in any field, especially when it happens suddenly and unexpectedly. Further complicating matters, sustainable investing has not sprung forth as a unified, fully developed investment approach. The many ways that sustainability is being applied to investing have made it difficult to come to a broadly agreed-upon understanding of what sustainable investing means and its scope. As a result, much of the criticism stems from a mismatch between what a critic thinks sustainable investing is or should be about, and how it is actually being practiced, often leading to claims of “greenwashing.” A case in point is a recent Bloomberg Businessweek critique of MSCI’s environmental, social, and governance ratings.

Provocatively titled The ESG Mirage, the article argues that MSCI's ESG Rating system "flips the very notion of sustainable investing on its head for many investors" because the ratings "don't measure a company's impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders."

The authors got it partly right: ESG ratings do attempt to measure the potential impact of the world on the company and its shareholders, even though that's an awkward way to put it.

More clearly stated, ESG ratings of companies, like those of MSCI, Sustainalytics, and many other data providers, attempt to assess the material impact of ESG issues on a company. (Sustainalytics is owned by Morningstar.) Investment analysts use ESG ratings and associated metrics to add an ESG dimension to their overall assessment of an investment.

But the Bloomberg reporters are mistaken to suggest that this approach flips the very notion of sustainable investing on its head. To the contrary, this idea--that ESG concerns are financially material and therefore can affect a company's bottom line--is an essential element of sustainable investing and a key reason for its rapid growth.

Furthermore, they are also wrong to suggest this has nothing to do with the broader impact of companies on the world. The notion that ESG issues can affect companies financially is not inconsistent with the view that sustainable investors can achieve a broader impact on people and planet. In fact, the two ideas are closely connected.

That ESG ratings measure ESG risks and opportunities for companies may be a revelation to the authors but, in fact, it is this very approach that has fueled the growth of sustainable investing. The rationale for focusing on what the article dismissively calls "the potential impact of the world on the company and its shareholders" was first articulated in a 2005 United Nations report called Investing for Long-Term Value, which led to the creation of the UN-backed Principles for Responsible Investment. It serves as a sort of a founding text on ESG investment analysis, reading in part:

"In a more globalised, interconnected and competitive world, the way that environmental, social and corporate governance issues are managed is a key part of companies' overall management quality that's necessary to compete successfully…

Companies that perform better with regard to ESG issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value."

It was this rationale, operationalized through ESG metrics and ratings, that convinced asset managers and large institutional asset owners to incorporate ESG considerations into their investment processes.

The Bloomberg Businessweek article argues that investments that use ESG ratings to measure the "potential impact of the world on the company" are misleading investors who think sustainable investing should be about the broader impact of companies on the world. But if you are an investor who wants your investments to have some broader positive impact on the world, the way to do it is by helping convince companies to address the material ESG issues they face.

In a subsequent Bloomberg Green companion piece, How to Get an ESG Rating Upgrade, the authors list 25 issues that, if addressed, can improve a company's ESG rating. They imply that these are easy fixes that don't amount to much in terms of broader impact.

Here are a few items from their list relating to employees:

• Conduct an annual employee satisfaction survey
• Reduce employee turnover
• Offer employees stock ownership
• Allow employees to report grievances
• Have a whistleblower protection plan
• Offer diversity training or programs
• Appoint a chief diversity officer

Here are a few items from the list related to customers/products:

• Protect customer data
• Hire a chief information security officer
• Improve product quality
• Exclude the use of toxic chemicals in products
• Institute "responsible" advertising standards

Here are a few items from the list related to climate/environment:

• Set an emissions target
• Offer green bonds (if a bank)
• Sell some electric cars (if an automaker)
• Adopt a recycling policy

Here are few items from the list related to corporate governance:

• Adopt business ethics, anti-corruption, and anti-money laundering policies
• Add "independent" board members
• Create an ESG committee at the board level

While this is not a comprehensive list of issues that ESG ratings cover--in fact, it was compiled by the authors seemingly to trivialize ESG ratings--if all companies that are falling short on these issues were to address them adequately, the broader impact on the world would be significant.

In a year-end Harvard Business Review article, sustainable business consultant and author Andrew Winston notes how far business leaders have come in recognizing the importance of sustainability issues: "No business leaders seriously doubt that sustainability should be on the agenda, and companies are moving from incremental improvements to bolder, systemic approaches that create a net positive impact on the world."

This is owing, in no small part, to the explosion of ESG into the mainstream. “The message is that managing climate and other ESG issues is core to business value.”

So there is a definite link between ESG ratings and data as they exist today and the broader idea of impact. That said, as sustainable investing matures, I expect there will be greater emphasis on evaluating companies based on their broader societal impact. In fact, many ESG data providers are working on developing impact metrics to complement existing ratings. That’s because not only investors, but customers, workers, and regulators will increasingly expect companies to have a net positive impact on the world. It will become central, not only for the license to operate but for financial success.