Enriching the "E" in ESG Analysis

There has never been a greater need for clarity on the ESG performance of companies, but with criticism of ratings methodologies mounting, how can raters, investors and corporates achieve the highest levels of confidence in environmental data?

ESG analysis and ratings have increasingly come under the spotlight in recent months in response to a convergence of concerning trends. Most serious of these is the escalating climate crisis itself, with noticeably more volatile and severe climate events in 2023, such as a devastating wildfire season in North America.

This demands an effective response which will necessarily involve companies and their investors understanding their environmental data and the effectiveness of their action on climate change. ESG ratings are a critical part of this process.

At the same time, ESG ratings have come under scrutiny from numerous quarters, with issues being raised to varying degrees of sincerity. On the one hand, firms, investors, academics and politicians have expressed legitimate concerns with ESG ratings – primarily the lack of regulation, poor comparability and wide divergence in scores between raters, and opaque methodologies and data sources. All of these factors will need to be addressed to establish greater trust in ESG ratings.

On the other hand, climate change deniers and anti-ESG campaigners (primarily in the US) have launched a backlash against the use of ESG ratings in decision-making by firms and investors. They claim that using environmental data to make investment decisions is financially harmful and should not be allowed. This has placed political, financial and legal pressure on financial institutions to reject ESG analysis, and threatens the role of ratings agencies as a key source of environmental data and a tool for action on climate change.

Transparency in data and methodology is key

As a result of these trends, it is growing increasingly important for ESG raters to provide rich, detailed, transparent, and comparable information and data. This will ensure investors have the clarity they need to have confidence in ESG ratings, and help to dispel some of the concerns (legitimate or otherwise) about the sector.

There are a range methodological and data approaches that ESG raters can apply to ensure alignment with best practices, but adhering to the principles of transparency and accountability is critical to building confidence in environmental data.

Demand for this is clear from both the sustainability and investment communities. Respondents to the ERM SustainAbility Institute’s ‘Rate the Raters 2023’ survey, which include over 1,800 sustainability and investment professionals, listed credibility of data sources, quality of methodology, and disclosure of methodology as the three factors of highest importance when determining the quality and usefulness of ESG ratings.

Unsurprisingly, the most successful and trusted ESG raters are those which already follow this best practice. Providers such as CDP and S&P Global ESG publish detailed methodologies alongside their analysis, offering customers the transparency which is essential to establish a reputable ratings business.

The success of this strategy is indicated by their performance in the ‘Rate the Raters 2023’ report, where corporate respondents ranked CDP and S&P Global ESG first and second respectively, among 13 leading ESG ratings providers, for both the quality and usefulness of their ratings.

Evaluating data approaches – self-reported vs ‘big data’

These results would suggest that being open and demonstrating sound methodological practices is more important to establishing trust in ratings than the types of data sources and methodology used. Nevertheless, there is also a debate to be had about the comparative merits of different data sources used to inform ESG ratings. Indeed, healthy competition and diverse data sources and methodologies are a natural and important part of the ESG ratings ecosystem.

There are broadly three methodological approaches taken by raters – using only self-reported company data, using only ‘big data’ from public sources, and a mixture of the two.

Interestingly CDP, the most highly regarded ESG rating firm according to the ‘Rate the Raters 2023’ report, solely relies upon self-reported data derived from responses to its proprietary questionnaire.

By not considering external sources, CDP is making a deliberate choice to focus on how companies are presenting their own performance with regard to ESG. CDP is very clear about this in its publicly available methodology, in which it explains the reasons behind this decision, as well as the potential risks of this approach and how it will address them.

RepRisk, another independent ESG rater, takes a contrasting view. The firm’s methodology claims that as it is now ‘well-accepted that self-reported information is not reliable data’, it disregards this in favour of a comprehensive survey of external public sources to screen for potential ESG-related risks to companies.

This use of ‘big data’ has the advantage of showing how corporate ESG performance is viewed externally, gives a much fuller picture of the wider ESG landscape, and is more responsive to events which may affect a company’s exposure to ESG risks.

However, the use of big data itself is not without risk, particularly when it is being deployed to make investment decisions. Extracting useful insights requires judicious application of AI and machine learning, which must be carefully tuned to produce accurate information. There is also a risk that regulatory bodies could classify some forms of big data collection and usage as inside information, rendering it unusable. On top of this, there are concerns around privacy for data collected in this way, which runs the risk of breaching data protection regulations.

Finally, there are question marks over the relevance (or indeed legality) of including data that is not financially material (i.e. only regarding environmental impacts) in ESG ratings.

No ‘one-size-fits-all’ approach to ESG ratings

Consequently, a perhaps imperfect ‘middle-way’ is demonstrated in the approach taken by most ESG raters – which use a combination of self-reported data and alternative data sources to produce balanced analysis of a company’s ESG performance. This is the methodology applied by industry leaders such as S&P Global ESG, Deutsche Böerse-owned ISS-ESG, and Ecovadis.

Ultimately, the best data and methodological approach to ESG ratings will vary by industry and customer base – and raters would perhaps do well to acknowledge that there is no one-size-fits-all approach. Instead, being open and clear about data sources, methodology and research limitations will be crucial to improving market confidence in ESG ratings and ensuring they have a positive role to play in tackling the climate crisis.

Written by Andy Pope

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