If you are a CEO or a CFO and your board has urged you to deal with ESG or even to hire a CSO (Chief Sustainability Officer) to manage the issue, there are probably a few questions you are asking yourself. This short article avoids the obvious ones because there are many articles and evidence that show that ESG matters and delivers results.

However, there is a lot of confusion about how ESG is measured and what should be done in order to make the most of it.

How ESG is measured

The first thing to know is that there are as many ways as ESG rating agencies. How many rating agencies are in the market? They are not 5 or 10, the number is over 125[1]. Many of them are very specialized companies whose core business was providing ESG ratings, but there are many others, including the big players in the rating business, that are entering or have entered that space through the acquisition of small players. Despite the above, the most commonly used ESG rating agencies are a few among which are the following: KLD (MSCI Stats), Sustainalytics, Vigeo Eiris (Moody’s), RobecoSAM (S&P Global), Asset4 (Refinitiv), and MSCI (Morgan Stanley International Capital).

With the context described above, it is not strange that investors struggle when trying to understand and use the ratings, mainly because significant differences between ratings are commonplace. A study conducted by the MIT Sloan School of Management[2] showed that the correlation on average is just 0.54, ranging from 0.38 in the worst case, to 0.71 in the best case. Just focusing on the best case, that means that every three out of ten decisions will be biased based on the selected rater. This same study found out that the divergences could be placed into three sources by order of significance in the result: 1) differences in scope of categories, 2) measurement of categories, and 3) weights of categories. Additionally to that, it was also detected a “rater effect” where a rater’s overall view of a firm influences the assessment of specific categories, in the sense that a firm that receives a high score in one category is more likely to receive high scores in all the other categories from that same rater while other raters do not score that firm that high.

So, the conclusion that can be drawn from the above to answer to the first question is that there is still harmonization to be done in the way this is measured and should be used more as an indicator on the right direction rather than a fact. If this is not your approach you may find yourself struggling to improve your ESG performance because the signals you receive from different ESG rating agencies are different and you do not know where to emphasize in terms of actions that are valued by the market. This leads to the second question

What should be done to make the most of the ESG efforts?

There are different strategies depending on the goals and context. Two of them would be as follows

The first one will serve a company that is seeking funds from a lending organization and wants to maximize the amount of funds or improve the lending conditions based on the ESG rating. In this case the short term solution would be understanding which ESG rater they are using and place the efforts on those areas the rater values more.

The second one will serve a company that is seeking funds in the stock exchange. This is a trickier one since it is difficult to know which rater would be the one to choose. This means that some additional effort is required since this corporation may know who the most common investors are and what the most used raters they follow, and then, apply the same concept than above.

Nevertheless, the above two strategies are just focused on getting a better rating. The real value to the company lays more on the results of implementing ESG policies and procedures rather than the assessment of the raters of them.

Conclusion

So, the real advice here is that the CEO, CFO and or CSO should be focusing their efforts and resources in applying those policies and procedures that based on their analysis of risks and opportunities on the ESG space give them better results in the long run, regardless of what the ESG rates say. Good policies and procedures to address ESG issues will always provide both good ratings for the short term, and, more importantly, better operational and financial performance in the long run. Do not build your policies and procedures based on the expectation that your rating will be better, it is exactly the opposite, build your policies and procedures based on what is best to mitigate your risks and enhance your opportunities and the rates will reflect that sooner or later (a few raters sooner and all later) and keep the eye in the ball:

The paradigm is evolving and the value of a company cannot be dissociated anymore from its performance on, and the influence it receives from the environmental and social components.

[1] Mark Kramer, Nina Jais, Erin Sullivan, Carina Wendel, Kerry Rodriguez, Carlo Papa, Carlo Napoli and Filippo Forti, “Where ESG Ratings Fail: The Case for New Metrics,” Institutional Investor (September 7, 2020) Available here

[2] Florian Berg, Julian F. Koelbel, and Roberto Rigobon, “Aggregate confusion: the divergence of ESG ratings,” (May 2020) Available here