ESG Metrics: Ratings or Ravings

By Michael Moran, Skytop Contributor / September 30th, 2022 

 

Michael Moran is a geo-strategy and sustainability expert whose books and documentaries have won awards and influenced the global debate for decades. He currently serves as Chief Markets, Risk & Sustainability Officer at Microshare, a global leader in Smart Building and ESG data technologies, and is a Lecturer in Political Risk at the Josef Korbel School of International Affairs at the University of Denver. 

Moran is a former Principal and Chief US/Macro Analyst at Control Risks and led digital content strategy at the Council on Foreign Relations, winning three Emmy Awards for documentary work while there. He also has launched successful editorial offerings for Roubini Global Economics, the Carnegie Corporation of New York and other clients and was a member of the launch team at MSNBC.com, where he served as a columnist and international editor for over a decade. 

He is author of several books, including The Reckoning: Debt, Democracy and the Future of American Power, of which Ian Bremmer of Eurasia Group wrote: “Moran is a sharp thinker and fine storyteller, and The Reckoning is a terrifically engaging read.” Moran is co-author with economist Charles Robertson of The Fastest Billion: The Story Behind Africa’s Economic Revolution and a novel, The Fall (2015). His analysis of political risk and international affairs has appeared regularly on CNN, CNBC and other major broadcast outlets and in the pages of The New York Times, the Financial Times, Forbes, Foreign Affairs and Foreign Policy magazines and many other journals. 


Inflation and its Drivers 

The reemergence of inflation has provided opponents of Environmental, Social and Governance (ESG) metrics and other green initiatives with a powerful weapon. As the cost of living and doing business shoots up, the “buy in” needed from society at large to pursue things like a net-zero economy or gender pay equity is fraying. Put simply, inflation and its drivers, from Vladimir Putin to the new tariff regimes surrounding technology and China, are a Godsend for those who see such pursuits as futile, quixotic or just economic heresy. 

The Role of a Corporation 

The objections come in many forms, but most boil down to a fight over what the role of a corporation is in modern society. Is it, as Milton Friedman famously proposed, limited to creating shareholder value? Or should the interests of other stakeholders – workers, communities, minorities, the human race – also be figured into the mix? 

The Demands of an ESG Ratings Industry 

For proponents, ESG is about harnessing market forces in service of sustainability, transparency and social well-being. By rating companies’ performance on key indicators, the thinking goes, ESG will mobilize investor pressure for more transparency about the impact of operations on the environment, race and gender issues, human rights, and democracy. 

The concept has been embraced by many investors, and corporations have reacted accordingly to align their conduct (or at least their marketing) with the demands of an ESG ratings industry that applies complex algorithms and methodologies to a company’s performance. Firms like Trucost (owned by financial ratings firm Standard & Poor’s), MSCI (owned by Morgan Stanley), Refinitiv (owned by the London Stock Exchange), and Sustainalytics (owned by the financial analysis firm Morningstar) conduct detailed surveys of corporate operations, scouring everything from the carbon footprint of their real estate portfolio, the gender and racial makeup of staff and executive suite, to supply chain and third-party labor practices. 

Some Standout Cases 

Such work has, indeed, produced some standout cases, where corporate brand and share prices have both benefited from good ratings. Blackrock, the world’s largest asset manager, has been a vocal and pioneering advocate of designing investment funds that steer clear of carbon intensive companies out of its portfolio, though the strong performance of energy firms this year thanks to Vladimir Putin’s blood-soaked foreign policy has seen some backsliding in its assets under management, and some withering criticism, as well. 

Patagonia, the global sports apparel giant, is another leading ESG light and has led the charge in removing from its supply cotton that originates in Uzbekistan, Tajikistan, or China’s western province of Xinjaing, where forced labor and child labor is endemic. The company’s founders, the Chouinard family, are so serious about ESG that they decided against a public offering earlier this month and instead “donated” the entire firm to two trusts to ensure non-financial goals can be pursued as aggressively as profits. “We had very little confidence in meeting with quite a few potential investors that the integrity of the company would be protected” if the firm went public, CEO Ryan Gellert told CNBC earlier this month. 

For the most part, the firms rated “best” by the dozens of ratings firms plying the trade these days are household names. Lists abound, but a frequently consulted “best of” is produced by Just Capital, an ESG investment advisory, whose top table includes names like Microsoft, Bank of America, Intel, PepsiCo, Apple, AT&T, Accenture and other global giants of finance, manufacturing and technology. 

The Opposite of Transparency 

Any one of them can be challenged. Do Microsoft’s massive server farms, often the highest consumers of energy in a given region, disqualify it? (Obviously not). Is the low wage structure for bank tellers a problem for Bank of America. Apparently no. 

The very complexity of these ratings methodologies creates the opposite of transparency, encouraging all sorts of “greenwashing” about actual corporate aims and fund performance. It is precisely this weakness that ESG’s enemies have seized upon, and this is also the driver behind current EU regulation on corporate sustainability disclosure, as well as the SEC’s current rule making efforts to compel US publicly traded firms to spell out their impact on the environment and what plans they have going forward to improve. 

Conflicts of Interest 

It also creates conflicts of interest, and these are clearly apparent simply by looking at who is doing the rating. To some, the ESG metrics industry, which topped $1 billion in revenue this year, looks a lot like the industry that rated mortgage-backed securities back in the early 2000s, when supposedly disinterested bond ratings agencies (Moody’s, Fitch, and S&P) were hired by Wall Street banks to rate their mortgage-backed securities offerings. Virtually all the offerings wound up with AAA+ ratings, sparking a financial crisis when many turned out to be junk. Not surprisingly, the parallels have regulators worried. 

Conforming to the Moment 

What’s more, in the ESG industry’s rush for customers, firms have naturally tended to take proprietary approaches to their ratings, all claiming to have the best algorithms. These algorithms sometimes create wildly disparate results for the same company’s performance and apply methodologies that don’t necessarily conform to the moment. 

For instance, public and market awareness of the social component of ESG has been transformed by the COVID-19 pandemic, as worker-employer dynamics have shifted and people have become aware of the importance of the safety of indoor working environments. Should an office that installs smart building sensors to monitor air quality be rewarded? What about a meatpacking plant that invests in HVAC upgrades for better ventilation to prevent the spread of viruses among staff? Unfortunately, the kinds of activities taken to secure, retain and reassure workers will not necessarily be captured by current ESG methodologies. 

Inconsistencies 

The results of these inconsistencies can be problematic. Some ratings firms, for instance, categorize natural gas producers as somewhat green due to the vital part natural gas has to play in the net-zero transition period. Others see them as carbon economy villains. Wells Fargo Bank garners low ratings from many ESG data firms because of deceptive business practices that in the past led to steep fines for its home lending and retail banking operations. Yet in 2020, the bank won an award from S&P for “sustained excellence” in its approach to the environment after entering into a long-term energy contract with companies that have solar and geothermal energy in their supply chains. 

A study by MIT’s Sloan School of Management found that differing methodologies make nonsense of the idea of rating a firm’s performance. Since investor pressure is the engine of change in ESG theory, the divergent signals that ratings firms send blunt and even prevent progress. “Improving scores with one rating provider will not necessarily result in improved scores at another,” the study’s authors wrote. “Thus, ESG ratings do not, currently, play as important a role as they could in guiding companies toward improvement.” 

Lack of Standard Definitions 

John Hale, a leading commentator on sustainable investing, warns that the lack of standard definitions is more than simply an annoyance but in fact presents an existential risk to ESG investment strategies. 

“An ill-defined concept is vulnerable to attacks and caricatures from opponents,” he wrote on his blog for Morningstar recently. “This happens in politics all the time. When an appealing candidate or new idea emerges, opponents try to move quickly to define them in negative terms before they can fully define themselves. That’s happening today both inside and outside the investment world.” 

The battle is joined. Defining what ESG actually measures will take time, and with regulators in Europe and the US now more engaged, it may eventually happen. But don’t count on the ESG metrics industry to do it. There’s simply too much money to be made muddying the waters.

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