Looking For The Best ESG Rating Method? Good Luck With That.

Vapor rises from cooling towers in South Africa. (Photographer: Waldo Swiegers/Bloomberg)

Looking For The Best ESG Rating Method? Good Luck With That.

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As investors across the globe look to put their money in companies that fulfill certain environmental, social and governance standards, analysts in India are preparing benchmarks to measure compliance.

Several scoring systems have come up to judge whether some of the nation’s biggest companies are committed to averting a climate catastrophe, have socially responsible practices and good governance benchmarks. A common ground for assessment, though, is yet to be found.

The spurt in data providers for such ratings stems from the fact that funding for companies is being increasingly tied to explicit ESG goals. Over $40 trillion has been pumped in globally in ESG-focused investments, according to ESG Risk Assessments & Insights Ltd. In India, 7% of the assets under management are ESG investments. That number's likely to rise to 30% by 2030.

"At the core, ESG-based investing is a recognition of the fact that companies do not function in a vacuum. Businesses need to be evaluated through the lens of sustainable, responsible and ethical practices in the same way as its financial performance," said Amish Mehta, president and chief operating officer, Crisil Ltd. "Investors are paying increasing attention to this and ESG has become imperative. A company that scores higher on ESG is expected to manage risks and capitalise on opportunities better."

International rating agencies such as Standard & Poor's, Fitch Ratings and Moody's Investors Services, index providers like MSCI Inc., financial data providers like Bloomberg L.P. and Thomson Reuters—dozens of companies are already putting out ESG scores. Enough for at least one firm to publish a ‘Rate The Raters’ report annually. Such ratings are gathering pace in India too, with at least three new scorers emerging in the last four months.

Still, interpreting scores can be a tough ask with a myriad of variables and data points being used. And the approach will change based on who you ask.

ESG Ratings Rush

Take Edelweiss Financial Services Ltd.'s scorecard of the top 100 listed companies, primarily for institutional investors, was launched in May. They track 40 metrics with equal weights to the E, S and G. These have been shortlisted based on the availability of data in the public domain, said Alok Deshpande, executive director of institutional equities, Edelweiss Securities. If a company is not disclosing any of those metrics, they get penalised to an extent in their score.

"ESG, at the end of the day, is a proxy for the sustainability quotient of the business. When you look at ESG scores, you are trying to quantify the quality of sustainability." Deshpande said. "It adds stability. The number of shocks for your business will go down. That's the way to look at it."

But Crisil, which came out with its own scorecard in June for 225 companies, takes another route. It tracks 100 parameters and has different weightage for E, S and G based on company performance and the relative performance of the sector it belongs to. "The framework ensures we can compare diverse sectors such as mining and technology on a single scale," Mehta said.

Then there are more complex models like the one deployed by ESG Risk AI, founded by Acuite Ratings. "We have built a detailed taxonomy with 525 indicators. But we have to make sure that all indicators are looked at within a context," said Chairman Sankar Chakraborti. "In a bank, for instance, child labour would not be a critical factor. We have manually identified factors like these for 200 sectors and given a materiality score. So, child labour will have low materiality for banks but it could be higher for mining companies."

Methodologies continue to vary the more you look. But trends are similar.

Information technology firms, banks, financial services companies tend to have better ESG scores. The likely culprits, like mining, metals, cements and real estate generally find themselves in the bottom half.

Yet, multiplicity of scorers and ratings also makes it possible for companies to shop around for what suits them best while investors seek transparency and standardisation.

Hunt For Standardisation

Transparency plays a key role in boosting these scores. A more transparent company is likely to score better. Two years back, three researchers from the University of Chicago Booth School of Business studied corporate social responsibility reports of S&P 500 companies to determine their real ESG credentials. One of their findings was that companies generally had higher scores, if they just disclosed more.

Even with transparency, the quality of data each company gives differs, making it harder to put these ratings into context.

"Disclosures by companies do challenge the accuracy of ESG models," said Hetal Dalal, President and Chief Operating Officer at the Institutional Investors Advisory Services, which also has its own ESG model. "For the models to be more accurate the first step will be at the company end—to define the data set and collect it."

For Indian companies, too, the data is often neither comparable across years nor across companies even if these are in the same industry. From an investor standpoint, it is important to see the scores as an indication rather than an absolute.
Hetal Dalal, President & COO, IiAS

And this is a problem that plagues ESG investing globally. From the U.S. Securities and Exchange Commission to Europe’s new Sustainable Finance Disclosure Regulation, different jurisdictions are coming up with disclosure standards.

In May, the Securities and Exchange Board of India unveiled new disclosure standards for the top 1,000 companies under the Business Responsibility and Sustainability Report. These will replace the currently used Business Responsibility Report framework, and have a bigger emphasis on ESG parameters. But they will only be mandatory from FY2022-23, and are voluntary for FY22.

ESG rating data providers say that the absence of standardised, good quality disclosures, does not invalidate their ratings today. "Any analysis, not just ESG, will always depend on what's out there in the public domain," Deshpande said. "That doesn't make the analysis inferior."

"Yes, general disclosure levels are weak, they're about to get better. But based on what's out there in the public domain, every agency tries to assess and give the best assessment that they can," he said. "So, a well-governed coal company and a badly governed coal company would still stand out vis-a-vis each other based on these metrics."

Keeping disclosure quality and standardisation in mind, regulators are now pushing for cross-border uniformity with the Financial Stability Board, an international body of G20 economies that includes India, publishing a roadmap to tackle this challenge.

There are also private efforts to create harmonised disclosure standards applicable across jurisdictions, such as those by Global Reporting Initiative, Climate Disclosure Standards Board, International Integrated Reporting Council, Sustainability Accounting Standards Boards, and Carbon Disclosure Project.

Leading professional bodies and standard-setting organizations such as CFA Institute and Value Reporting Foundation are also at work. Meanwhile, securities regulators' body IOSCO is consulting with the IFRS Foundation on sustainability disclosure standards.

Finding common ground will be a big challenge as countries seek to protect their own interests. Vikram Gandhi, a professor at Harvard Business School, told BloombergQuint that it took over a century for stakeholders to reach a financial disclosure mechanism—IFRS—that is consistent across companies and regions. But uniform sustainability disclosures could come around faster.

"I think getting to a similar thing around sustainability issues is going to be the next holy grail," Gandhi said. "There's tonnes of effort being put into it. You need to have regulators come together, companies come together and investors come together to make that happen. It's a work in process."

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