Consultant Matt Jones explores the issues with ESG ratings and how Small World is taking a different approach to assessing some of the world's largest listed equity companies.
How can you really tell if a company cares about its impact on people and planet? Assuming you can't talk to the management team and hook them up to a lie detector, where else would you turn for a reliable answer? Investors looking to better understand their own Environmental, Social and Governance (ESG) impacts are increasingly asking this question, and those willing to dig deep enough should be unhappy with the options they have.
Many companies disclose their impacts publicly, releasing information such as emissions data, employee diversity statistics, and land management plans on an annual basis. These companies may set targets, develop strategies, and assign someone to be responsible for managing, and hopefully reducing, their ESG impacts. They may also carry out assessments that explain the environmental and social benefits of their products and rationalise complicated offsetting schemes that will make them net zero by 2030. For investors looking only to tick the ESG box, this information is likely to be enough to score a company highly. In fact, this box-ticking exercise has grown into its own industry, known as ‘ESG ratings’. Ratings companies sort through endless sustainability reports and aggregate ESG data in to one single score per company. Investors can then incorporate this data in their financial models and build portfolios with companies that meet a certain rating agencies’ threshold.
It’s as simple as that: investors integrating ESG ratings can now be confident that the companies they invest in are doing everything they can to tackle the climate crisis, look after their employees, increase biodiversity, manage water usage correctly, offset their emissions appropriately and also effectively manage their business in accordance with the law.
Although this sounds great, it is unfortunately not true. In the last two years of our work on ESG we’ve found that more often than not, companies cannot be relied upon to explain their ESG issues clearly, regularly saying one thing and then doing another. We spend weeks researching individual companies, attempting to validate their claims and understand the coherence of their ESG approach. Our ESG assessments may not always be repeatable as they rely on the subjectivity of our researchers and their ability to gather and present evidence. They may also take a lot longer to bring together than other ESG ratings systems due to their high level of detail. However, we have found that our approach provides a clear picture of what the priority issues are for certain companies and how they are currently managing them, arming investors with suggestions that they can use to effectively engage.
When you really look hard at ESG issues, they become increasingly complex and challenging to aggregate into a single score
Often you don't need to look far to find examples of where a little more detail on ESG claims goes a long way in understanding the effectiveness of a company's approach. A report published by the New Climate Institute and Carbon Market Watch explored the net zero targets of 25 large companies representing around 5% of global emissions [1]. Many of these companies have made broad targets without specifying how these will be achieved or without disclosing the total emissions reductions that will make the target achievable. As a result, when looking at their targets in slightly more detail, the report found that the companies had collectively only committed to reduce 0.5GtCO2e of the total 2.7 GtCO2e proposed in their targets, with the missing 2.2GtCO2e being either excluded or achieved through offsetting. For context, 2.2GtCO2e is greater than the annual emissions output of Russia in 2018 (1.99 GtCO2e) [2].
An even more confusing example comes from the Russian nickel miner, Nornickel. Nornickel are attempting to claim their own carbon reductions as credits to then offset their emissions, achieving carbon neutrality without engaging in any genuine carbon removals. For example, if Nornickel emissions are 150kg of CO2e and it reduces its emissions by 75kg of CO2e, it then wants to use this 75kg reduction to offset another 75kg of CO2e, supposedly rending its emissions ‘carbon neutral’.
This madness isn't captured in ESG ratings, primarily because it takes time and resource to understand whether a company’s claims will enable any actual progress towards reducing its ESG impacts or not. ESG ratings opt for breadth rather than depth, carrying out assessments on thousands of companies across the market. Raters therefore often only ask ‘yes’ or ‘no’ questions of companies. Has the company pledged to achieve net zero by 2030? If ‘yes’, then +5 points for their ESG score, and so on. This is a simplistic example but demonstrates the premise behind much of the ESG rating universe, that the objectivity and repeatability of ESG assessments is more important, and profitable, than actually exploring the nuance and detail of company’s actions on ESG issues and the effectiveness of these actions.
When you really look hard at ESG issues, they become increasingly complex and challenging to aggregate into a single score. The mining industry provides a good example, where strong narratives on ‘transition minerals’ and watery targets are positioning miners as solid investments on ESG grounds. Large miners like Rio Tinto and BHP are right, we do need more lithium, nickel, and other minerals key to the electrification of our energy system, but do we need them at the expense of our natural world? Can we justify more intensive and greater extraction if it will continue to endanger key species and crucial fresh water eco-systems? Partner these issues with a history of controversial actions in sensitive indigenous locations and a lack of detail on how miners intend to decarbonise and it becomes impossible to objectively weigh up one problem up against another.
Going back to our original question, it is clear that ESG ratings are not currently fit for purpose when it comes to understanding whether a company really cares about its impact on people and planet. Ratings might be helpful for a quantitative metric-based approach to measuring ESG, but they do not capture the important details of complex issues. To really understand whether a company cares, you need to dig deep and look hard at what the company is both saying and doing regarding ESG issues. If we continue to just skim the surface of understanding a company’s impacts, then our ability to hold these companies accountable for their actions and reward those making positive change will be severely limited. Investors should therefore be encouraged to dig deeper and ask more questions of how companies are managing their ESG impacts, rather than providing them with a list of boxes to tick.
[1]New Climate Institute and Carbon Market Watch (2022). Corporate Climate Responsibility Monitor 2022. URL: https://newclimate.org/2022/02/07/corporate-climate-responsibility-monitor-2022/ [2] Climate Watch (2022). Global Historical Emissions. URL: https://www.climatewatchdata.org/ghg-emissions