Our first blog in this series looks at the importance of corporate non-financial reporting and the rising interest in ESG investing. However, we also saw how an increase in reporting has not resulted in a tangible improvement in resolving sustainability issues. This time, we will discuss the reasons in more detail.
The problems in linking sustainable investment with sustainable outcomes can be categorised into 3 broad areas.
- Problems deriving from the underlying ESG data that is used to inform decisions
- The differences in defining the materiality of sustainability issues (by both the companies reporting and the ESG ratings providers)
- Accusations of greenwashing, often related to the information failures resulting from the first two categories and can occur at corporate or fund creation level.
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ESG data problems caused by corporate reporting:
Corporate reporting has led to several significant ESG data issues. In 2021, a Harvard Business Review article summarised the shortcomings in corporate reporting, describing it as “non-standard, incomplete, imprecise, and misleading.” These measurement issues lead to consequent problems within the underlying ESG data.
- Incomplete Reporting: Voluntary reporting allows companies to choose which aspects of their operations to disclose. This is particularly an issue for companies evaluating opaque and complex supply chains – and is reflected in the disclosure numbers; according to CDP over half of companies that disclose their carbon emissions, do not attempt to report under the Scope 3 category. This lack of consistency makes it challenging to compare businesses’ contributions to addressing these impending sustainability challenges, since evaluating Scope3 emissions is crucial to a company understanding and effecting influence upon their supply chain impacts. It also allows companies to choose which standards to follow, allowing cherry picking of information included in their reporting.
- Imprecise Targets: Companies often set ESG targets without a clear understanding of their real-world impact. A 2016 report that analysed over 40,000 CSR reports found that just 1% integrated ecological limits and science-based targets into product design, resulting in an information gap between goals and their resulting impact. This in turn means the costs of negative externalities are not factored into the actions of businesses and can result in long-term damages to various stakeholders.
- Incorrect Priorities: A further disconnect can occur in determining targets that prioritise the most pressing issues. To allow decision-makers within businesses to assess priorities, they need to understand the link between their activities and the resulting impacts on the stakeholders such as people and planet, in a comparable way. But with no agreement on a metric to compare and report their impacts on social and environmental issues, difficulties arise in prioritising the businesses’ sustainability goals.
- Misleading Reporting: The diversion in perspectives on stakeholder vs shareholder capitalism can create divergence between what a company deems material to report on and the link with the actual impact resulting from the company’s operations. This is because sustainability topics can be identified as being “material” using the narrower concept of the impact on the company, or a broader context that includes the impact on stakeholders and broader society.
These issues underscore the need for standardised, comprehensive, and precise ESG reporting practices to enable more meaningful comparisons and informed decision-making.
ESG data problems caused by ratings providers:
Ratings providers play a crucial role in shaping ESG data. Once companies have reported their ESG performance, the data is collected, analysed, collated, and benchmarked by private companies, who extract insights and produce rankings and ESG related indices. The resulting data is sold to investors who rely on this information to guide sustainable investment strategies.
The top three ESG ratings providers, MSCI, ISS, and Sustainalytics, hold a significant market share, and provide market participants with information regarding the impact the corporation has on non-investor stakeholders. These data sources are integrated at various stages of the investment process to create different types of “sustainable” investment funds. However, various problems exist in the information being provided by ratings agencies.
- Incomplete Data: Ratings providers rely on disclosed data points, and companies often omit their most detrimental impacts, creating a distorted image of the company.
- Company Size Bias: With more resources available to publish favourable information, an ESG bias towards larger companies has long been established – one 2019 study by LaBelle et al shows that average ESG scores amongst peers tend to rise with market cap and that ESG investors are consequently creating an inadvertent large cap bias in their portfolios.
- Lack of Standardisation: Inconsistencies in disclosures and formal auditing processes make it challenging to compare measurements across companies and the sparseness of the data reported creates challenges for the ESG data and ratings providers in how to fill the gaps.
ESG ratings methodologies: Opaque and subjective
Problems also arise because of the ESG methodologies used in ratings agency assessments.
In response to gaps in company reported data, some providers will use the industry average disclosures as proxy data. However, according to SASB, 90% of known negative events are not disclosed either in SEC filings or sustainability reports, implying the worst impacts remain hidden using this method.
The methodologies applied to derive the rankings also involve subjective judgments of the weightings applied to the reported data around each issue. It has been well documented that, as a result, there is a significant diversion in the ESG scores derived from these different methodologies, with the correlation of scores for the same company averaging at just 0.54 according to an MIT report looking at 6 of the top ESG ratings providers.
Furthermore, the lack of transparency in the methodologies that are used compounds the problem for investment teams trying to understand the dispersion in ratings, making it difficult to unpick the drivers of differences between providers, to determine which metrics to focus on, or indeed how to combine data from different providers.
ESG ratings: a one-sided Materiality Perspective
The materiality question raises itself again when it comes to the weightings the data providers apply to the various ESG issues to determine the ratings. MSCI, a dominant player in the ESG ratings system, takes the predominant view shared by most across these ratings agencies regarding materiality; namely that ESG measures the impact of the societal and environmental factors that are considered as financially material to the company.
A recent Bloomberg investigation into stocks receiving ESG upgrades by MSCI found that climate change policy rarely factors into their materiality considerations. One example upgrade was McDonalds, whose GHG emissions increase of 16% between 2015 and 2020 was assessed by MSCI as not posing a financial risk for McDonald’s.
However, by judging ESG factor materiality based on the potential impact of the world on the company, rather than the company’s impact on the surrounding natural and social systems and the underlying capital on which the company and other stakeholders rely, results in a skewed perspective that can disregard the mechanisms through which these sustainability impacts can turn into sustainability risks. Moreover, this narrow perspective of materiality creates a detachment between the ratings of a company and the sustainability related impact these assessments are purporting to guide.
Summary:
In this blog, we saw how problems created by the non-standardisation of corporate reporting resulted in sustainability measurement that was non-standard, imprecise, incomplete, and misleading. Furthermore, subjective, and one-sided perspectives of ESG issue materiality – both within corporate reporting and rating – combine to create an ineffective set of ESG data. It is this ineffective data that is guiding the creation of sustainable financial products that are generating headlines with recent reclassifications and greenwashing fines. Without an improvement in approach, ESG data will continue to create confusion in product oversight and risks derailing a critical movement that aims to integrate non-financial impact and steer capital towards businesses that are moving to address the sustainability challenges that lie ahead.
In our next blog we will introduce Route2’s V2S project in more detail and discuss how we aim to reduce the subjectivity and provide a more comprehensive assessment of the impact of companies within the FTSE 350 index.
Get in touch
If you would like to discuss our approach, or wish to find out more about our advisory services or Value2Society™ Accounting Software, please get in touch via info@route2.com.