Companies need to go beyond ESG ratings in order to make a real impact

ESG expert Brett Wallington unpacks why ESG commitments don’t measure impact on Earth and society.

Corporate reporting has gone through many changes throughout history, but none more significant than when financial reporting became mandatory, transparent and audited. As described in the recent Harvard Business Review article, “An ESG Reckoning is Coming” (March 2021), this key change sparked “a sense of accountability that social and environmental commitments desperately require”.

While they mustn’t be written off entirely, the trouble with existing ESG rating agencies and risk oriented firms is that they are only looking at the standardised ESG commitments. And although ESG ratings still play a crucial role in getting a handle on the ESG risks a business may face and ensure that businesses establish the correct policies, committees, plans and targets to mitigate those risks, it only tells half the story.
Therefore, we need to be going beyond ESG commitments and measuring real impact.

Why companies need to go beyond ESG ratings
The Bloomberg Businessweek has recently published a rather sobering analysis on MCSI, the largest global ESG rating agency, where they found the ESG ratings of the S&P 500 “don’t measure a company’s impact on the Earth and society”, but in fact “gauge the opposite: the potential impact of the world on the company and its shareholders”.

Furthermore, their research article titled “The ESG Mirage” (January 2022) goes deeper to cite real examples, showing the inward-looking nature of ESG ratings where “it’s all about whether the world might mess with the bottom line”. For example, when considering water stress, the MSCI rating system measured “whether the local community has enough water for the company, not whether the company is stressing the local water supply”.

When expanded to other key environmental issues such as climate change, they found that only one of the 155 ESG rating upgrades issued (i.e., an improvement in a score) was due to real cuts in emissions. Bloomberg Business week illustrates this point in practice, where BlackRock’s ESG Fund, while labelled as “sustainable”, is in fact more heavily weighted in 12 fossil fuel stocks than the actual S&P 500.

For these reasons, the limitations of these typical ESG risk analyses and ratings aren’t clear. It doesn’t give any indication of the value businesses create and the socio-economic and environmental capital it generates.

In a recent publication in the Sustainability Journal of the MDPI titled “Stakeholder Value Creation: Comparing ESG and Value Added in European Companies” (2021), it was concluded that “while theoretically a good social responsibility proxy, ESG indices cannot be used as an indicator of value creation for stakeholders”.

They go on to say that we need to “review the limitations of ESG ratings and establish that the relevant indices are not suitable for use in universal or absolute decision-making”.

Having measurable impact trumps setting up ESG policies
As is becoming clearer to those truly engaged in ESG and impact, there is a critical difference between setting up policies versus having a measurable impact in the real world.

The United Nations’ Sustainable Development Goals (SDGs) form the global framework from which to try and provide an answer, but in many cases, most companies only give them lip service, or what some call “SDG dropping”. The Harvard Business Review sums this all up quite simply: where “the connection between a company’s social and environmental impact and its financial performance continues to grow, companies ignore these trends at their peril”, especially with the growth of millennial investors entering the market.

As an ESG and impact professional, I have seen this demand grow first-hand, particularly with the Covid-19 pandemic supercharging the shift from just ESG risk, to real impact.

So how do we ensure that these companies follow through on their commitments as they face growing pressure to start answering the questions that current ESG ratings currently can’t, including: “What is the actual impact that the company has on the environment and society?”

There are new tools and technologies entering the market to measure impact and close the loop on ESG risk and SDG impact. Perhaps, through future collaborations with ESG rating agencies, we can start to gain a more complete picture of the inward-looking ESG risks of a company with the outgoing actual impacts, framed by the SDGs. This will finally give us a better idea of whether the company’s policies and management approaches are in fact turning into actions and creating valuable impact.