They mark a fundamental shift towards responsible capitalism, and firms can no longer choose which dimensions to satisfy, writes Ron Botes
ESG (environmental, social, and governance) ratings first surfaced publicly in the UN report Who Cares Wins, issued 20 years ago. At first the reaction to the global citizenship criteria provided was indifferent, but in recent years, investors and other stakeholders have begun use them to assess the impact and value of companies. The criteria encompass issues such as climate change, human rights, diversity, ethics, and transparency.
ESG ratings have become a definitive measure of good corporate citizenship, recognising ethical and efficient organisations – the heroes – and exposing organisations that lack insight into a sustainable future (the villains) for planet and people. In simple terms, ESG ratings have become a big deal, reflecting a company’s commitment to a sustainable future.
Organisations now look at ratings provided by ESG rating bodies as an internal yardstick, and externally as a benchmark against competitors.
Rating systems are mechanisms that guide decision-making and promote accountability. They now encompass a wide range of factors, from labour practices to carbon reduction, creating opportunities for companies to score points by aligning with progressive trends. They provide an opinion on a company’s sustainability profile, assessing exposure to sustainability risks and an organisation’s impact on society and the environment. ESG ratings aren’t just about compliance; they’re a strategic advantage for companies committed to sustainable growth, and therefore a powerful tool for promoting responsible investing and driving positive change. However, they may unintentionally incorporate bias, lack context, and be susceptible to manipulation.
Crazy comparison
And what are ESG ratings worth when tobacco companies do way better than – say – Tesla?
Comparing Tesla and global tobacco giant Altria illustrates the complexity inherent in ESG ratings: Tesla, which holds the biggest slice of the global electric car market, has garnered significant attention for its innovative technology and commitment to sustainable transport.
However, when it comes to ESG ratings, Tesla’s performance has been mixed. Widely used ESG ratings tool Sustainalytics scores Tesla much more poorly than Altria, despite Tesla’s environmental focus. Sustainalitics rates Tesla a medium risk, with 37 points out of a possible 100, thanks to its social and governance challenges. Altria, known for its Marlboro cigarettes, surprisingly outperforms Tesla with an ESG score of 84, thanks to its emphasis on diversity, social justice initiatives, and corporate progressiveness. The tobacco industry’s proactive stance on issues like board diversity and social impact plays a big role in its scores.
While cigarettes cause significant harm (more than eight million deaths annually), Altria’s strategic focus on diversity and social initiatives boosts its ESG standing. Tesla, despite its environmental mission, faces criticism for its lack of diversity and social programmes.
In the absence of other effective mechanisms, ESG ratings hold organisations accountable for their ESG practices, as these ratings are disclosed in the public domain. Ethical quandaries arise when the agencies lack transparency, or. manipulate data to make organisations appear more virtuous.
A second ethical concern arises where ESG ratings fail to balance stakeholders’ interests. A good ESG rating might please investors despite the company ignoring social justice concerns. ESG scores, depending on the rating agency, may exclude or render certain measures irrelevant or immaterial. And ethical dilemmas emerge when universal standards clash with contextual reality.
Cultural nuance
Another grey area arises where ESG ratings are global, and what is acceptable in one culture is not in another, such as the use of child labour. How should rating agencies navigate such cultural nuances and maintain consistency?
A fourth area of concern is greenwashing: organisations often cover themselves in glossy clutter and verbiage without true commitment to ESG. Ratings must expose greenwashing for what it is, and not penalise sincere efforts.
The final ethical consideration for ESG ratings is the ripple effect they have on economies, both local and global, given that good ratings attract capital and shape positive corporate behaviour.
Key measures
The key metric categories used to assess corporate ESG performance are environmental impact (eg greenhouse gas emissions), social impact (eg labour practices), and governance (eg board independence). Classification can also be done in terms of industry-specific metrics, or quantitative and qualitative metrics.
Ultimately, all three pillars – environmental, social and governance – are interconnected. A company cannot thrive sustainably without addressing each aspect.
An important question, often raised, is the fairness of ESG ratings. Like any assessment system, published ESG ratings are subject to scrutiny and debate. Assessing fairness involves making judgment calls on subjectivity (which is subjective in itself), data availability, materiality, scope, long-term approach as opposed to short-term, and transparency.
Because rating agencies may weigh various factors differently, inconsistencies between them may be perceived as biased. Also, because they rely on publicly available information, an organisation that discloses more information than competitors may see its rating improve.
Smaller organisations are at a disadvantage, as they are not usually in a position to supply comprehensive information. What’s more, what is deemed “material” may differ by industry, so rating agencies should be mindful of industry-specific nuances.
And because ESG rating bodies focus on larger organisations, many mid-sized to small organisations or in emerging markets (or both) are beyond their radar.
Either way, it’s essential to recognise that these ratings are not entirely objective. Subjective decisions are made when determining which factors to include in a rating and in deciding how to assign weights, and the conversion of ESG scores into letter grades or percentile rankings also involves subjective decisions.
ESG ratings also often incorporate qualitative assessments – for example, evaluating a company’s commitment to diversity or its community engagement – which again involve judgment and therefore subjectivity.
International norms
Global citizenship and geopolitics must be taken into account for organisations with international footprints, as the ratings agencies assess the extent to which organisations respect international norms, support human rights, subscribe to a circular economy, and comply with or evade regulations.
And no organisation can escape the weight of politics, as lobbying efforts, campaign donations, and interactions with politicians all matter. ESG ratings simply consider whether organisations are in tune with the political and legislative thinking of the day.
In addition, ESG audits – unlike financial audits – lack independent peer review, and regulation is required to prevent greenwashing and ensure market stability.
ESG ratings should be guided by transparency, fairness, and a hint of idealism to deal with several serious ethical issues.
Dun & Bradstreet, Sustainalytics, MSCI ESG Ratings, and Bloomberg ESG Disclosures Scores are regarded as top rating agencies. However, each has its own methodology and focus areas, something the organisations they rate often find confusing or frustrating.
MSCI ESG Ratings, for instance, use a rules-based methodology to identify industry leaders and laggards. It’s based on exposure to ESG risks and risk management relative to peers. Ratings range from leader (AAA, AA), average (A, BBB, BB), to laggard (B, CCC). However, MSCI’s methodology changes have led to frequent rating upgrades, raising questions about its credibility.
It should not come as a surprise, then, that the number of ESG disputes is increasing, or that their resolution plays a crucial role in shaping sustainable business practices worldwide.
Inherently subjective
It should be clear that while ESG ratings are valuable tools for investors, they are not infallible. Their fairness depends on robust methodology, transparency, and industry context. This means investors should approach ESG ratings with awareness of their inherent subjectivity, using them alongside a range of information sources and perspectives to make informed decisions, and interpreting them in the context of the unique challenges and opportunities each sector faces.
Integrating ratings into investment processes can help manage risk, identify opportunities, and promote responsible investing. However, they should not be used as the sole basis for assessing potential investments. From time to time their subjectivity and the lack of consensus among rating providers has led to mispricing stocks, bonds, and funds, so investors should consider a holistic view of an organisation’s performance, including financial health and long-term sustainability.
Companies with excellent ESG ratings enjoy several benefits, including attracting investors, as good ESG ratings signal ethical and effective leadership, better borrowing costs thanks to evidence of risk mitigation, and find it easier to attract and retain talent, thanks to their enhanced reputation.
Their ranks include Cisco Systems (commitment to net zero emissions by 2040 and contributions of $477-million to community programmes); Verizon Telecommunications (committed to generating, by 2025, through renewable resources, half the energy it consumes); and Apple (has cut emissions by 23-million tons by changing its materials, using clean electricity, and turning to “low carbon” shipping).
Unilever, Danone, and Patagonia have demonstrated remarkable ESG progress, showing that ESG improvements are achievable, impactful, and contribute to a more sustainable and responsible business landscape.
Conversely, poor ESG ratings may deter investors, signal the likelihood of regulatory penalties, and attract less favourable borrowing rates.
And given that sustainable practices are crucial for long-term viability, companies that ignore ESG risks may also struggle to adapt to changing market dynamics.
Looking ahead
ESG factors are no longer niche concerns, but integral to investment decisions. Investors increasingly recognise that financial performance and sustainability go hand in hand, which means companies that prioritise ESG practices are likely to attract more capital and thrive in the long term.
Efforts to standardise reporting frameworks (such as IFRS, SASB, GRI, and TCFD) are expected to improve organisations’ transparency and comparability on the ESG front. Governments worldwide are introducing ESG-related regulations with which companies will have to comply.
Meantime, investors need to stay abreast of evolving policies and moves such as adoption of technology that enables better ESG data collection, analysis, and reporting, or blockchain, which can improve supply chain transparency.
ESG ratings mark a fundamental shift toward responsible capitalism and good corporate citizenship. As investors, companies, and policymakers collaborate, ESG will shape a more sustainable and equitable future.