ESG ratings: A call for consistency
The case of Boohoo has led to more cries for harmonisation of ESG standards and ratings – but is this realistic? David Burrows reports
Allegations that workers in the Boohoo supply chain were underpaid and subjected to poor factory conditions – including lax safety protocols relating to COVID-19 – were “not only well-founded” but “substantially true”, according to an independent review published last month. The issues were also “endemic”.
The findings will surprise few. Exploitation of this vulnerable workforce has, in many ways, been fast fashion’s open secret. That it happened to Boohoo was also predictable: campaigners, MPs and the media have all raised red flags before. However, the mud never stuck enough to distract consumers or investors. “The firm is paying only so much attention to how big companies are meant to behave,” said The Economist in 2019. “Boohoo’s facts are millions of young customers and runaway growth, a combo that seldom goes out of style.”
Boohoo has been making money, so why ask questions? After all, its ratings in relation to environmental, social and governance (ESG) criteria held up. Indeed, the company ended up in a number of sustainable funds. How? And what does this mean for the future of sustainable finance and investment?
Opinions, not facts
COVID-19 has created a surge of interest in sustainability risk disclosure, and the role of ESG criteria in financial markets continues to grow, with sustainable funds launching at “record pace” according to Fitch Ratings – one of the ‘big three’ credit rating agencies. Commentators have pawed over market data to show that companies with high ESG ratings are proving more resilient to the pandemic.
However, an ESG rating won’t always help us discern the heroes from the villains. “It is easy to blame the providers,” says Wolfgang Kuhn, director of financial sector strategy at ShareAction, a charity promoting responsible investment. “They give opinions, and when these turn out to be inaccurate, the blame usually falls on them.”
“The information that decision-makers receive from ESG rating agencies is relatively noisy”
Like credit ratings, ESG ratings are opinions, not facts. However, the questions being answered are far trickier. While a credit rating focuses on the probability of default, ESG reaches across everything from climate change risks and workplace accidents to packaging footprints and board diversity. “We’re dealing with topics which can sometimes be difficult to quantify, and even more difficult to distil into a single number,” explains Carlota Esguevillas, a consultant at Simply Sustainable.
Much also rests on the data – the quality of which is hotly debated. ESG ratings providers generally calculate scores using publicly available information, including company statements, annual reports, news stories and reports from NGOs. Any assessment can be hamstrung by a lack of disclosure.
Research by consultancy Ricardo found that half the FTSE 100 have not conducted any future climate scenarios to inform their risk register. Others have found gaps, too. “While we know that women are underrepresented in leadership positions, accounting for only 21% of board directors of the 2,000 most influential companies globally, we found that many companies in the apparel industry fail at disclosing quantitative and qualitative gender data to stakeholders,” says Dan Neale, social transformation lead at World Benchmarking Alliance.
While some metrics fail to materialise, others are difficult to quantify. Consultants are struggling with how to measure the ‘S’ of ESG, which has risen to prominence during the pandemic. Researchers at MIT Sloan and the University of Zurich found that ratings agencies don’t always agree on how to measure a company’s performance in relation to human rights. In their paper ‘Aggregate confusion: the divergence of ESG ratings’, they described how the scope of the ESG categories, measurement of them and how they are weighted all differed between agencies. “The correlations between the ratings are on average 0.54, and range from 0.38 to 0.71. This means that the information that decision-makers receive from ESG rating agencies is relatively noisy.”
Such ambiguity can leave investors and corporates with a headache. The former can’t decipher the leaders and laggards, while the latter are given mixed messages about what’s expected of them and the actions that will be most valued by the market. In April, an International Organisation of Securities Commissions (Iosco) report revealed there are three recurring themes during discussions with regulators and the industry (asset and fund managers, audit firms, credit rating agencies and so on): multiple and diverse sustainability frameworks and standards, including sustainability-related disclosure; lack of common definitions of sustainable activities; and greenwashing and other challenges to investor protection.
The pandemic, meanwhile, is helping fan the flames across a number of sectors. Think about what’s happened at meat plants, with outbreaks of COVID-19 and site closures. “The working conditions are not suddenly bad,” says Christy Spees, an expert in sustainable food systems with shareholder advocacy group As You Sow. “They’ve been bad for a long time.”
Calls to harmonise the ‘alphabet soup’ of arbiters have gathered steam. “There is little consistency, transparency, rigour and scrutiny,” says Simon Cole, founding partner at Reputation Dividend, which tracks 200 of the UK’s largest listed companies. Measures not only differ markedly but sometimes “go in different directions”, he adds. “One agency might show a company ‘improving’ while another has it ‘declining’.”
Iosco secretary-general Paul Andrews reportedly wants to standardise the ESG rules with a new set of guidelines that offers the same at-a-glance reference point but remains “granular enough to be meaningful”. A taskforce will also probe greenwashing in asset management and examine the methodologies used by ratings agencies, according to the Financial Times. Is change in the air? “There is no globally accepted set of metrics for reporting on how a company delivers for society and our planet,” PwC global chairman Robert Moritz noted last month, in a blog about a new list of metrics developed by the big accounting firms and the World Economic Forum to address this gap. The wheel isn’t being reinvented, though: the four pillars (governance, planet, people and prosperity) are underpinned by 21 core and 35 expanded metrics and disclosures, taken from existing standards and aligning with the UN Sustainable Development Goals.
Investors have also begun to pile on the pressure. Some are demanding companies report using the Sustainability Accounting Standards Board (which focuses on the financial impacts of sustainability) and the Task Force on Climate-related Financial Disclosures (TCFD). Kuhn notes: “It rarely seems to occur to investors to tell the companies they own and control to give them what they need.” The UK government is planning for all large asset owners and listed companies to provide disclosures in line with TCFD by 2022.
Pendragon Stuart, a consultant at Sancroft International, says TCFD will have a significant impact because it goes beyond the ‘tick box’ approach of some ESG ratings. “It speaks the language of risk mitigation and value creation,” he explains. That it has oversight from the G20 adds weight. Others point to the EU non-financial reporting directive, which is being reviewed to improve disclosure and reduce greenwashing.
However, those looking for a silver bullet in all this will be disappointed. “These initiatives aren’t the answer to either the world’s problems or an investor’s dilemma when considering responsible investments,” says Colin Curtis, founder of TBL Services, a consultancy. “We all want an easy life, and investors just want to make decisions without having to do a lot of background work,” but “perhaps that aim just isn’t achievable”.
ShareAction’s Kuhn suggests the excitement about ESG harmonisation is “understandable” but “misguided”. A “realism” needs to develop that acknowledges that this can only go so far, he explains. “As for Boohoo: if you didn’t see it coming, maybe you were asking the wrong questions.”
David Burrows is a freelance writer and researcher.