What Does a Company's 'Social-Responsibility' Rating Really Mean to You?
In January 2018, BlackRock CEO Larry Fink called on public company CEOs to not just deliver good returns for shareholders, but also provide “a positive contribution to society.”
A traditionally passive investment manager, BlackRock’s evolution to take an active stance on issues seemingly unrelated to the bottom line was applauded by some and criticized by others, but ultimately left one important question unanswered: What does a focus on social and political issues actually mean for the millions of retail investors who rely on investments as the foundation for their retirements?
To try and answer that question, investors frequently turn to dedicated ESG ratings agencies in an effort to better understand how companies perform on these issues. After all, if passive funds and other major institutional investors are calling on companies to prioritize societal issues, there must be a clear way to determine who is doing well at “doing well”.
But as a new report just released shows, all too often the performance of ESG rating agencies lead to more questions than answers.
Titled, “Ratings that Don’t Rate: The unproven and unscientific world of ESG ratings agencies” the paper released by the American Council on Capital Formation reveals that ESG ratings may actually do more to mislead investors than to provide them with genuine insight into a company’s performance.
The most concerning issue the paper uncovers is the fact that the ESG ratings system is overwhelmingly driven by how much information a business decides to disclose. As the author notes, this allows “companies with historically weak ESG practices, but robust disclosure, to score in line with or above peers despite having more ESG risk.” In other words, bigger organizations which can devote substantial resources to disclosure typically surpass smaller counterparts who do not have the same sized reporting departments.
This discrepancy has led to some absurd results. For instance, after Volkswagen was caught cheating on emissions tests conducted by the Environmental Protection Agency, the company continued to maintain an ESG rating above the peer average.
Meanwhile, Tesla Motors, a company that manufactures electric vehicles with reduced emissions and no major environmental scandals, boasts a below average ESG rating. The primary reason? Volkswagen, which is based in Germany, discloses more information to comply with requirements set by the European Union than U.S. based Tesla.
While proponents of ESG investing argue that the system can help investors mitigate risk, a lack of standardization in disclosure requirements has led to significant omissions. In fact, the ACCF report reveals that 90 percent of known negative events about a company were not found in SEC filings or sustainability reports.
Worse, an analysis of thousands of sustainability reports, which are unaudited, found a significant number of data omissions, unsubstantiated claims, and inaccurate figures.
That lack of standardization is clearly apparent among different ratings agencies, where each has their own metrics for developing a company’s ESG score. Some agencies evaluate at little as 14 ESG performance indicators while others may look into as many as 1,000.
Beyond traditional rating agencies, proxy advisory firms like Institutional Shareholder Services (ISS) have also begun to move into the ESG rating industry. Already under attack for providing consulting services to the same companies they are assessing, the arbitrary nature of the ESG rating industry leaves scope for a company like ISS to further boost demand for consulting services in a new arena.
ISS has even made new acquisitions over the past year, including ESG consulting and portfolio management firm IW Financial and ESG ratings and sustainable investment research firm oekom research AG. Without some kind of regulatory framework, there is little to stop them from requiring disclosures that are as much about selling their services, as improving performance and enhancing a company’s environmental and social metrics.
Given these issues, it is alarming that BlackRock and the other large passive investment funds continue to promote political objectives as a fundamental of investment. Though alluring, their argument that companies who work to obtain better ESG ratings will perform better financially, because they are also mitigating risks that could impact the bottom-line, is impossible to accurately assess under the current system. Their evolution to become active investors should come with the requirement that they disclose their methodology for analyzing a company’s contribution to society, in order to preclude conflicts of interest.
If investors are to truly factor social and environmental goals into their investment strategies they need standardized, transparent, and accurate information about the companies they are investing in to make good decisions, mitigate risk, and increase returns.
PR stunts might make for good headlines, but real ESG ratings must be improved to reflect their stated purpose of alerting investors’ risks and opportunities. If they don’t, retail investors everywhere will suffer.
