3 Reasons Why ESG Ratings Still Matter and Will Remain Relevant
For the better part of the last two years, financial media, law firms, and political activists have made repeated critiques of the ESG rating industry. The naysayers cite inconsistent methodologies, investor demands for underlying data as opposed to top line scores, and the mishmash nature of all the information that goes into a single score. In short, they claim that ESG ratings are rapidly becoming obsolete.
Fairly, some of the criticism is warranted.
Nevertheless, the in-vogue dismissal of the ESG ratings industry is shortsighted. At a minimum, it overlooks several key advantages of ESG ratings that aren’t offered elsewhere. These unique attributes of the system ensure the ongoing relevance of ESG ratings, and they underscore the need for companies to continue focusing on elevating their ESG scores.
Here are three reasons why ESG ratings won’t go away anytime soon.
1. Scoring Variability Is a Feature, Not a Flaw
Inconsistency in the scores doled out by the various ratings agencies is arguably the most significant criticism of the ESG ratings industries. It’s not uncommon for the same company to receive a “good” score from one rater and a “bad” score from another.
However, the variability in the scores has much more to do with intentional differences in what the raters are assessing than it does with poor methodology or a flawed system. For instance, Sustainalytics scores companies based on their ESG risks. Conversely, MSCI scores companies based on their ESG performance.
Because the raters use two very different lenses, it’s no surprise that their scores don’t always match up. Individually, the scores offer valuable insight for stakeholders who may be evaluating companies in a variety of different ways. Collectively, they help tell a more comprehensive story about an organization’s overall approach to ESG.
2. Passives Need ESG Ratings
Passive investment vehicles now account for about 35% of the global equities market. And a significant portion of passive funds are ESG-aligned—two out of every three ETFs created in 2021 had an ESG focus.
Importantly, passive funds (and index funds in particular) leverage ESG indices to dictate portfolio inclusion, and more often than not, they are based on companies’ ESG ratings. MSCI, for instance, offers more than 1,500 ESG-aligned investment indices and Refinitiv offers an additional 630 ESG indices. Nearly all of these indices decide where and how to place companies based on their ESG scores.
Estimates suggest more than $150 billion sits in passive ESG funds, and that number is growing. This means it is increasingly difficult for CFOs to ignore the tremendous impact that ESG ratings can have on their companies’ shareholder base.
3. Ratings Are Critical to Understanding ESG Risk
Investors evaluate ESG practices to better understand a company’s investment risk. Historically, investors have priced risk into cost of capital figures in their valuation models, looking at things like supply chain, consumer behavior, or macroeconomics. Yet, pricing in the risks of climate change, a lack of diversity, or energy consumption is still unfamiliar territory and continues to represent a major challenge for investors.
It is important to remember that understanding an industry and weighting topics based on relevance to a company is very complex work for which most buy-siders are not fully qualified. As a result, investors need ratings to navigate these uncharted waters. In fact, a 2020 survey showed that a staggering 98% of surveyed investors used ESG ratings in their investment decision-making process.
Regardless of faultfinders’ concerns with the system, investors still care about what the ratings say. And your business needs care, too.
Cut Through the Noise
The criticism of ESG ratings is unlikely to disappear. But neither will the ratings nor their importance to investors—at least not in the foreseeable future. Rather than discredit ratings firms, Clermont Partners concentrates on helping companies better understand rating methodologies, and we use those insights to improve companies’ ESG scores.
If you’re interested in unpacking your current ESG scores or proactively boosting your ratings, give us a call. We leverage a sophisticated set of tools to help companies enhance their ESG messaging and earn the scores their ESG efforts deserve.
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