Over the past decade, ESG ratings have grown in importance as the demand for ESG data by investors has drastically increased. Even though these ESG ratings are intrinsically different from corporate bond ratings and research analyst buy/sell designations, ESG ratings have grown to be accepted in a similar light. Since these ratings appear to nicely fit into the same category as their older counterparts on the surface ,when in reality there are underlying shortcomings that undermine their reliability today.
These ESG ratings have come under increasing scrutiny in 2020.
The traditional bond and equity rating agencies can be relied upon to identify the oncoming short term financial and operational risks associated with a business even if they are not always perfect. This is because, through mandatory disclosures, companies are required to make clear the current state of the business and any oncoming risks.
Experts are optimistic that the lack of mandatory disclosures could change as regulators are likely to address the overwhelming demand from investors that companies disclose pertinent ESG-related investment information.
The hope from investors is that with regulation comes standardization of data too. However, regulation alone might not be enough to fundamentally reshape the structure of ESG data, ratings, and the disclosure ecosystem. The various standard setting frameworks, which each provide guide rails for data disclosure, have each carved out their domain of expertise. This makes it more likely that there is no one clear ‘leading’ standard, but rather a potential amalgamation where overlap is minimal but confusion still remains. Over time, it is more likely that a company will continue to disclose to a handful of frameworks, and that data will continue to feed into their ESG ratings.
The key stakeholders within the ESG rating ecosystem are:
Underlying the need for various ESG rating agencies is the challenge of taking the unstandardized and messy data that exists today and re-package it in a way that is easily digestible for investors. Today there are several agencies whose ratings feed into publicly-traded indices or broader published industry rankings. Each one of these has its own merits for existing that are very valid. Whether focusing on a specific category like the Bloomberg Gender-Equality Index or targeting specific companies like JUST Capital, there is value in having more targeted clarity on specific ESG related performance. However, each rater operates independently, which disproportionately burdens companies to provide or verify the data that goes into their ratings today.
The fragmentation of rating agencies will persist because investors are hungry for access to more data. To make matters more difficult, because there is a heightened reputational risk for the companies to respond to all inbound requests for their ESG data from these rating agencies, there is increasing pressure to engage with all agencies. Both of these factors contribute to the growing number of rating agencies and the burden on companies.
As it stands today, companies disclose to three types of rating agencies. The first requires information submitted to be publicly available, and the second type allows a company to provide data that is not made publicly available. Typically, a company with an advanced ESG disclosure process will align it’s disclosing schedule to publish all the information to go into the ratings that require public information first. This information is typically made publicly available through a sustainability report, which usually discloses ESG data following accepted frameworks (GRI, SASB, TCFD). That way, company data that feeds into the ratings makes use of the latest available information. The challenge for companies is keeping track of what data is requested or required from each rating agency. It is critical to ensure that they disclose information in their public reports that satisfies the rating agency requirements.
The third type of rating agency collects publicly available information without direct input from the company then allows the company to either validate or refute this data. It is this bucket that can be the most difficult for all stakeholders. This iterative process of validating/refuting adds yet another layer of burden on the companies. The rating agencies also have had to manage an extensive data collection process themselves from the outside looking in. This costly and inefficient process is simply another output of a nuanced and unstructured ratings system.
Fortunately, the Caesar platform is not only making it easier for companies to collect more and more ESG data, but we are also working on creating processes to manage how companies share that information with these third-party reporting agencies. By creating greater transparency and access to ESG data, all three types of rating agencies will have more clarity and trust in the data that ultimately determines published ratings. We will accomplish this while continuing to drive home the importance of simplicity in our product so that Caesar can reduce the burden on the disclosing companies.