While Environmental, Social, and Governance (ESG) ratings are becoming more prominent with over $120 billion funneled into sustainable investments in 2021 (more than double the $51 billion from 2020), these ratings are an imperfect effort for sharing relevant information with investors.
A recent Harvard Business Review article made the argument for assigning companies a stand-alone rating focused solely on climate risk. Authors Felix and Milica Mormann believe that a climate-specific rating would help distill the complex information about a company’s carbon footprint and climate risk into a user-friendly format. They also believe that this shift would help avoid some of the flaws that currently reduce the impact of ESG ratings.
One prominent flaw of current ESG ratings is that methodologies and definitions vary between rating agencies. The Mormann’s use Tesla Motors, the world’s leading manufacturer of electric vehicles, as an key example. Electric vehicles are widely hailed as a major development in the global strategy to alleviate air pollution, reduce greenhouse gas emissions, and mitigate climate change, so it seems like a no-brainer that Tesla would perform extremely well when it comes to the environmental aspect of ESG ratings.
But while MSCI’s ESG index has rated Tesla at the top of the auto industry, FTSE rated the company’s environmental performance as zero — with Tesla falling behind oil-and-gas major ExxonMobil in terms of sustainability. This is only one inconsistency across ESG ratings that confuse investors and threaten to erode popular faith in the ESG concept itself.
We are hopeful that the creation of the International Sustainability Standards Board (ISSB) at the United Nations COP26 late last year will unify ESG standards. Time will tell and it is clear that when it comes to sustainability efforts we do not have any time to waste.