An ESG rating measures a company’s performance in environmental, social and governance impact. ESG ratings or scores aim to help conscious investors determine which companies are more ethical or sustainable, useful for what’s come to be known as ESG investing. With ESG investing on the rise, investors are now seen to prioritise triple bottom line achievements and long term corporate values in addition to profits.
However, ESG ratings have a long way to go in being effective interpretations of a company’s true environmental and social impact. This is because ESG ratings are issued by independent research firms and this lack of standardisation makes ratings hard to compare against each other. You can read more about that in our blog article, which explores the topic more in depth.
As the name suggests, ESG ratings look at a company’s environmental (E), social (S) and governance(G) performance factors.
Environmental factors include: carbon emissions, electronic waste, water sourcing and biodiversity and land use.
Social factors consist of consumer financial protection, supply chain labour standards, workers rights and workplace safety issues.
Lastly, the governance factor addresses issues such as executive compensation, composition of the board, accounting practices and tax transparency.
ESG ratings measure the ESG risks that can potentially affect the financial position of a company, not the risk on the stakeholders. Simply put, if a company’s greenhouse gas emissions pose significant financial risks, its ESG rating will reflect that. If the issue does not pose a material financial risk, then it will not be reflected in the ESG rating.
Have a look at McDonalds in 2019. McDonalds was producing 54 million tons of CO2 emissions in 2019, yet MSCI upgraded its rating after determining climate change did not pose a risk to the firm’s profits.
Another hot debate was when Philip Morris, the American multinational tobacco company home to Marlboro, made it to Dow Jones Sustainability Index after launching its new campaign on creating a "smoke-free world". This is all while its products still remain harmful and addictive to its users.
ExxonMobil and BP, arguably one of the largest contributors to global carbon emissions and threatening the livelihood of the planet, often score an average or "BBB" by MSCI ratings. For comparison, Moderna, the American pharmaceutical company that produced your COVID vaccine also scored a "BBB" in 2021.
Mondelez International on the other hand is in the top 7% (ranked 36 out of 591) companies within its industry with the lowest ESG risks, beating its rivals like Nestle, and Hershey’s by a sizeable margin. But Mondelez’s supply chain is rife with ongoing child labour issues, which has garnered increasing scrutiny from consumers and shareholders. But their ESG score remains unaffected by the presence of child labour in their supply chain, exposing yet another flaw in the way ESG is measured.
So a question for the readers - Should ESG rating reflect how the business prospects will be affected by these ESG risks or should it reflect how the corporate practices are actually impacting on stakeholders (environment and society)?
The second issue with ESG rating is how weights are assigned to each factor (E,S,G) for each firm. Unfortunately, each factor does not carry an equal weight, and measuring each category depends on its importance and relevance to industry peers. While this may seem like a logical and legitimate approach, here's why it’s flawed.
While there are issues of weightage being based on human judgements and insufficient information produced by the companies, the primary issue here is how this weightage model allows companies to score high ESG ratings while neglecting and harming a certain group of stakeholders because they are performing well in other criterions.
Companies like Microsoft and Alphabet often score a high - or "AAA" - rating , qualifying them for ESG funds. Their high-ratings owe to low carbon emissions, but often overlooked is how much indirect influence these companies have outside of their operations in our economy, society and politics. Recently, Microsoft was offering their employees travel benefits for those seeking abortion. But at the same time they were also funding the Republican Attorney General Association. This shows a lack of consistency between their public-facing persona and their influence on society through political spending.
Coca-Cola, who had been recently under hot water for being a sponsor of COP27 despite being named as the one of the world's largest plastic polluters, currently ranks within the top 7% (38 out of 591) of food companies, just below Mondelez International as per Sustainalytics. How does this happen? The firm scores well on issues on corporate governance, greenhouse gas emissions and funding research for sustainable alternatives, well enough for it to "cover" for its contribution on plastic pollution and health risks of its product.
Being able to look at the whole picture is essential when it comes to weighing up risks businesses pose to our planet and our communities. In order for us to be in agreement about which businesses are heading in the right direction, we must first define what that ‘right direction’ is. Only by staying active and aware can we challenge and push the corporate world into a better future, and it will take collective power and effort to make this happen. So next time a seemingly bogus ESG rating makes your eyes practically roll out of your head, take a deeper look at where that rating went wrong and use the information to inform future decisions.