ESG Rating Systems

Transparency in an organization has never been more important to investors than it is now to ensure an investment fits the moral standards an investor lays down for themselves.

The introduction of the internet has significantly helped investors gather information, but as ESG becomes an increasingly important factor for investment decisions, the requirement for firms to be more transparent around how well they fulfil the ESG role is truly becoming a unique selling point.

In addition to transparency, the accuracy and reliability of a company’s rating based on their actual ESG performance is one of the biggest issues faced by those who want to be ‘sustainable’ investors. So, what can be done?

Firstly, let us consider the pitfalls of the current ESG rating system using the example of Boohoo. The fast-fashion company (which owns PrettyLittleThing, Nasty Gal, MissPap, and recently bought Debenhams) was found to have been sub-contracting manufacturing in Leicester to factories where workers were being paid less than the minimum wage and were exposed to poor health and safety measures. To everyone’s surprise, the ESG rating system MSCI gave Boohoo an 8.4 rating out of 10 for “supply chain labour standards”. How could this be?

To explain, we refer to a report in the Financial Times detailing research conducted by MIT University which found that the correlation between 6 different rating companies was on average only 0.54. The correlation in this case is a number between 0 – 1, 1 being perfectly correlated and 0 being no correlation. The value of 0.54 means that ratings systems are not consistent enough for investors to be able to rely on them in their bid to establish themselves as sustainable investors, a correlation much closer to 1 is required for this.

In particular, the report showed that the higher the ESG rating of an organisation overall, the more likely it was to be unreliable.

For investors, this means they should be more cautious about the reliability of a company’s true ESG performance when considering a firm with a high ESG rating. This is an obvious oxymoron, as an investor wants to entrust their capital to an organisation who meets their ESG standards, and those standards must be high.

The question is how to turn unreliable ESG ratings into figures that correlate with actual performance.

Initially, an ESG rating is created by a system that considers different categories. Each rating system is slightly different, but they have the same general processes: they look at industry specific factors and how well a firm can respond to how these risks may impact their ESG performance.

By way of example, a mining company would consider how much water the company uses (environment) and what water control processes they have in place to meet their environmental obligations and raise those standards above the industry norm. Here the risk is that water becomes a scarce resource, and a company that uses lots of water will be at risk of not only losing money, but also using a resource which now has a serious environmental impact. Is this deemed to be a high risk in the future? How much impact will an increase in

price and scarcity affect this firms operations? These are all questions that a rating attempts to summarise.

A further example might be a consumer finance company. How they manage their cyber-security (social/governance) could be a consideration here and again, how they are raising industry standards to meet their social/governance strategy. The risk here is that if the company’s cyber-security systems are far behind the industry norm, they are more at risk of having valuable, private information stolen from them.

In both examples, the risks are then given an individual weighting and normalised (a statistical method to allow the comparison of firms of different sizes) relative to all the other companies in the industry. The more likely the factors are to have an impact on the firm’s performance the lower the overall ESG rating.

Returning to the findings of the MIT researchers in the Financial Times report, they discovered that each rating system used slightly different categories, organised those categories differently and measured them differently. This obviously leads to rating systems generating very different numbers, and unless an investor understands every single system and is prepared to read through all the different types of indicators to understand each rating, it is impossible to compare results effectively.

Moreover, it was found that there is some confusion between raters as to what factors should be included in an industry ESG rating. For example, in the mining company, the research states that some rating systems will consider a company’s water usage as an ESG factor, whereas other systems would not. This is obviously extremely important because when it is unclear what a rating system has disregarded, it makes it incredibly difficult to understand exactly what the rating is actually measuring and assessing.

As a responsible ESG led investor, where does this leave you? Quite simply, you must look at multiple ratings systems to compare results. If the company has been highly rated, you must be extra cautious as research shows us this is where the correlation is at its lowest. This means that you should spend time researching the company you want to invest in: understand their practices, the industry they operate in, what may make them sustainable or unsustainable and most importantly of all, be sure of what each ESG rating specifically measures. The benefit of multiple rating systems that are different is that it forces you to seek the truth, and although at present it is a difficult task, you will be able to make a much more comprehensive decision. But do be aware that the data isn’t always of the best quality: full transparency about a company’s production methods and operating systems is tough to achieve.

Decide, as an investor, what measures are most important to you: is it environmental factors like careful water usage or social policies like worker welfare or perhaps governance strategies like boardroom diversity? Once chosen, align your investments with organisations who fit your criteria precisely and rely less on ESG ratings per se for the time being.