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Exploring EGS ratings: 'Aggregate confusion'

Problems and proposals

The Environmental, Social and Governance framework for assessing investments, companies and programmes is confusing and opaque for outsiders even after nearly 20 years since it made its first mainstream appearance in a 2004 UN Report. MIT/University of Zurich researchers have found 709 different indicators of ESG in 64 categories.

The stock market for ESG-focused investors is huge, though. A 2022 report says: "A total of 3038 investors representing over $100 trillion in combined assets have signed a commitment to integrate ESG information into their investment decisions."

So here's a quick rundown of some of the issues, problems and proposed solutions.

The Corporate Finance Institute has a web-page updated on 6 June 2023 (LINK) outlining ESG's history. The first ESG rating agency, Eiris, was apparently established in France 40 years ago.

CFI credits the first mainstream reference of EGS to a report, commissioned by U.N. Secretary-General Kofi Annan and partly financed by the Swiss Government, entitled "Who Cares Wins" ( PDF LINK).

It set out "Recommendations by the financial industry to better integrate environmental, social and governance issues in analysis, asset management and securities brokerage".

The endorsing institutions included major investment companies and banks.

The report included a section on transparency by companies about ESG, and noted:

"In 2002, of 16 leading oil and gas companies analysed by the World Resources Institute, 11 failed to mention climate change as a business risk in their annual reports. This, despite the fact that climate change is widely recognized by oil and gas managers as being a critical issue for the industry" (35).

The financial specialists recommended stock exchanges to include ESG criteria in listing particulars for companies (ESG). It added:

"Other self-regulatory organizations, professional organizations, accounting standard-setting bodies, public accounting entities, rating agencies and index providers should all establish consistent ESG standards and frameworks" (33).

SEC proposals in 2022: 'potentially costly and challenging'

The U.S. SEC finally produced proposals on climate change disclosures in March 2022 (LINK), but companies said the data required will be "operationally challenging and potentially costly to acquire", according to participants in an Ernst & Young Think ESG webcast (LINK).

But by then 17 stock exchanges were already offering "green bond" sections, focused mainly on climate change mitigation, giving the labels additional visibility to investors (LINK).

One major problem is the difference in the ratings promoted.

An MIT/University of Zurich group published a paper in 2019, updated in 2022, analyzing "The Divergence of ESG Ratings". Its title "Aggregate Confusion".

The researchers have concluded: "A rater's overall view of a firm influences the measurement of specific [ESG] categories."

However, the correlation between the six major ESG raters are low (0.38 to 0.71, when complete agreement would be 1.0., i.e. 100%, while credit ratings of firms are 99% correlated).

"In other words, the disagreement is substantial" (8), and the lowest correlation was the governance correlation (averaging 0.30).

They warn:

"ESG rating divergence decreases companies' incentives to improve their ESG performance. Companies receive mixed signals from rating agencies about which actions are expected and will be valued by the market."

"Although ESG ratings have incompatible structures, it is possible to fit them into a consistent framework that reveals in detail how much and for what reason ratings differ" (4), the scientists argue.

But getting there will require substantial action:

"Researchers should vet data providers carefully and avoid relying too much on one single rater" (5).

In addition, there is disagreement over specific environmental, social, and governance categories. And the weighting of various categories in the final ESG varies considerably between raters.

"For example, the three most important categories for [ther rating firm] KLD are Climate Risk Management, Product Safety, and Remuneration.

For Moody's ESG, the top three are Diversity, Environmental Policy, and Labor Practices.

This means there is no overlap in the three most important categories for these two raters.

Only Resource Efficiency and Climate Risk Management are among the three most important categories for more than one rater" (13).

What to do?

Their advice:

"Investors can use our methodology to reconcile divergent ratings and focus their research on those categories where ratings disagree.

For regulators, our study points to the potential benefits of harmonizing ESG disclosure and establishing a taxonomy of ESG categories. Harmonizing ESG disclosure would help provide a foundation of reliable data. A taxonomy of ESG categories would make it easier to contrast and compare ratings."

The group notes:

"Measurement divergence is most influential in the categories Climate Risk Mgmt., Product Safety, Corporate Governance, Corruption, and Environmental Mgmt. System.

"These categories are natural starting points for further research into enhancing measurement approaches in ESG ratings" (21).

Some problems are glaring. In the favourite rater for academics so far "divergence [from other raters] is very pronounced" (21). So scientific researchers can

Investors can see why the rating agencies diverge and investigate why, or rely on one whose results align with their objectives (22).

For regulators, "requiring ESG rating agencies to map their data to a common taxonomy would make such a comparison much simpler" (23).

"Some form of categorization is essential," the scientists insist.

BlackRock, the world's largest asset manager, reported in 2019, when over 1,000 ESG indexes had been instituted, that ESG-focused investments "have matched or exceeded returns of their standard counterparts, with comparable volatility".

In 2020 the Centre for Sustainable Enterprise (CSE) published a report focused on the UN-backed Sustainable Stock Exchanges Initiative (SSE), launched in 2009 (LINK).

"Today, the SSE has 96 Partner Exchanges, covering 51,943 listed companies and over $88 trillion in U.S. domestic market capitalization," it reported. "Almost every major stock exchange has joined the SSE in the past decade" (5).

Currently, 81 exchanges offer training on ESG topics but only 49 have markets covered by an ESG index and only 34 have mandatory ESG listing requirements (LINK).

At the end of June 2023 it was announced in Geneva that the UN's "Climate Change High-level Champions" approved the net-zero target framework for exchanges to align their operations with the goals of the Paris Agreement (LINK).

Swiss stock market guide

Switzerland's Stock Exchange offers a downloadable Investor Relations Handbook (LINK) setting out new regulation affecting ESG that came into law this year.

"Sustainability requirements are lightly regulated in Swiss law compared to other jurisdictions, in particular the EU," it notes (144).

The regulations from 1 January 2022, after voters rejected an effort to introduce a law "protecting human rights and the environment", come into effect in 2024 for the 2023 financial year.

They are modelled on EU regulations and cover only large companies. Their non-financial report must cover "environmental matters, in particular the applicable CO2 goals, social issues, employee-related issues, respect for human rights, and combating corruption" (148).

A Federal Council (Government) ordinance passed on 23 November 2022 said it would require "disclosures not only on the financial risk that a company incurs as a result of climate-related activities, but also on the impact of the company's business activities on the climate. In addition, the company has to describe the reduction targets it has set for its direct and indirect greenhouse gas emissions, as well as how it plans to implement them" (LINK).

The Swiss exchange says that only one of the exchange members that issue sustainability reports does not follow the standards promoted by the Global Reporting Initiative (LINK to GRI). This has a section on enhancing the credibility of sustainability reporting, though organizations are not required to use its methods (28). But it does recommend external assessment of its sustainability reporting to ensure quality and credibility.

The new EU regulations

The Swiss exchange's handbook also has a section on the EU's Regulatory Framework on Sustainability Reporting, in force since 2018. This "requires large EU companies to disclose information on how they operate and manage social and environmental challenges", including anti-bribery and anti-corruption as well as diversity but imposes no detailed disclosure requirements (155).

"As a result, investors are not given a truthful picture of the sustainability risks facing the reporting companies," the handbook observes.

It seems obvious that despite all the efforts to agree international standards, nothing is making it easy for investors to decide on ESG investments without a lot of research on their own, and decisions based on their own principles rather than general rules.

What business leaders say

For at least a decade, the Swiss-based World Economic Forum has gathered together business leaders and academics from all over the world to work out strategies for companies to sign up to ESG.

In 2021 two major Forum associates agreed with the university researchers:

"A coherent, comprehensive system of corporate disclosure is needed to ensure markets can understand risks and opportunities related to social and environmental issues" (LINK).

At its famous Davos Annual Meeting in January 2023 the Forum announced that 137 companies have included its Stakeholder Metrics including sustainability activities into their public reporting (LINK).

As a prelude to the 2023 Davos, the Forum's website highlighted an op-ed by a leading industrialist who argued "We must not lose sight of the importance of ESG, despite the recent backlash":

"Truly sustainable investing will be key to supporting the transition to a greener and more sustainable future." (LINK).

The Forum's YouTube videos run with subtitles such as "Implementing ESG for Corporate Governance" (LINK).

The YouTube Social Impact Show also has videos on "Getting started with ESG reporting, metrics and measurements" (LINK) and "How to develop a successful Strategy for your business (with examples)" (LINK).

It shows you do not need to be part of a "billionaires' club" to enact ESG principles.

Reaction of investment expert Patrick Geddes, author of 'Transparent Investing'

Investment expert Patrick Geddes, author of Transparent Investing, comments: "The first and most widely accepted [use for ESG rating] is to provide better financial analysis for predicting stock performance, including both risk and return.

However, there is no more a single scoring metric for stock market risk or return for ESG drivers than there is for any other economic driver behind stock price behaviour."

"Secondly, some investors want to conform their portfolios to their values for non-economic motivations, i.e., to try to match the ethics of the investor with the ethics of a company. That motivation does not lend itself to standardization since so many people define ethics and their own value system so differently. That’s at least part of why the weighting schemes may differ so much.

"I’m not arguing that there isn’t a lot of improvement available from standardized taxonomy, but I don’t agree with the implication that there’s one clear and indisputable methodology that just needs organizing.

*Governments or stock exchanges may well need to standardize disclosure, but the scoring won’t necessarily ever become as uniform and correlated as bond credit ratings, which are based on a very narrow predictive ability around default risk — unlike ESG factors that serve so many different purposes for different investors and governments."

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