What Is All The Fuss About ESG Ratings?

The recent growth of ESG in finance cannot be denied. It was originally adopted as a tool to ensure investments go to environmentally and socially responsible organizations (along with satisfactory internal governance systems – hence the “G”). The standards, protocols, and tools to measure and report on ESG-related performance has matured to the point that climate-related disclosures are required of certain publicly traded companies in Canada, the U.K. and the EU.

With any change comes resistance, and that has come from many directions. Environmentalist detractors argue that ESG reporting promotes greenwashing, or the manipulation of ESG to portray performance that is better than reality. Another complaint is that ESG reporting can conflate environmental, social and governance factors. More specifically, ESG reporting could conceal issues along individual metrics by blending them in overall performance reporting. In fact, The Economist published an article entitled, “ESG should be boiled down to one simple measure: emissions,” that argues for less blending of reporting on multiple parameters, along with addressing other ESG related challenges.

To the contrary, there are many conservative detractors who feel ESG reporting goes too far altogether. Former Vice President Mike Pence argued that ESG regulation is a way for “the left to accomplish what it could never hope to achieve at the ballot box or through competition in the free market.” Never mind that bureaucrats are not primarily demanding these mandates, but instead mainstream institutional investors are. The rating agencies provide a service to investors and those investors are demanding to understand social and environmental risks in regards to investments. Pence’s article also alludes to Elon Musk, who teed off on S&P Dow Jones Indices for delisting TeslaTSLA
from its S&P 500 ESG Index. This, too, was an unfounded accusation. The benefit of ESG is that it reviews an entity’s “E” impact as well as its “S” impact. Recent social injustices associated with lawsuits in Tesla manufacturing facilities played a big role in the delisting, and such incidents are well documented (and not mentioned by Pence).

While opposition to ESG principles grows with its level of adoption, the need to have such measurements is becoming clearer. The need to validate the social and environmental responsibility of a private-sector organization has been stated. The combination of identifying risks related to environment, climate change and social injustices and how a commercial entity adds to and manages those risks has driven ESG adoption and evolution. Even if you believe that private sector companies are only established to provide financial returns to its shareholders, you must agree that risk management along social and environmental risks requires quantification.

But then what about governmental entities? To start, governments do not serve to return a profit, but instead to protect the rights of people and preserve the public good, per the philosopher John Locke. ESG – a method to assess nonfinancial outputs from any operation – could help give tools for how well governments are functioning in the protection of those rights and preserving of the common good. While the standards to assess the fiscal solvency of a government are relatively advanced, what about the standards and tools to quantitatively assess how citizens are served and their needs are met?

So, given that governments have a “calling” to serve society, should we all not agree on the need to measure effectiveness and to quantify risks associated with lack of effectiveness? On the contrary, for example, when S&P announced it would rate ESG associated risks for states, leaders from the State of Utah penned an open letter to the President of S&P denouncing the move.

For governments, the argument against ESG as a whole seems unwarranted and political. One could concede, however, that there are credible arguments on what to measure as part of an ESG-based policy. The “E”’ in ESG is in itself a debate, since there are still members of our American community who do not believe in climate change or discount the impact of human-borne contribution to climate change.

The “S”, on the other hand, should not generate a debate on whether or not to measure. However, there may be a need to debate what social responsibility should be measured. Is it the government’s responsibility to provide adequate affordable housing? Should governments ensure equitable outcomes from their programs, or deliver programs race blind? If we agree there is human-driven climate change, then climate-related measurements are warranted. Then we must address greenwashing risk and challenges from blended reporting. Plus, are we double counting when we require the counting of Scope 3 emissions (the proposed SEC rules would only require limited Scope 3 emissions accounting while no pending rules require emissions accounting for public sector)? What do we measure in regards to social parameters?

To be clear, there are many unanswered questions, but the principles of ESG are still worthwhile. The benefits are different in public sector versus the private sector, but they exist in both arenas. In either case, the focus should be on capturing the positives, continuing the maturation process and generating steady improvements.