OPINION: As ESG risks and performance disclosures go mainstream, complex challenges continue to plague the system

As sustainable investing takes centre stage, can ESG benchmarking & ratings help identify leaders from laggards? Most importantly, can they spot and weed out greenwashing?

Earlier this month, western authorities raided a asset manager and the headquarters of its majority owner over allegations of misleading investors about "green" investments. According to news reports, prosecutors said they were following up on media reports and a whistleblower's allegations that the asset manager sold investments as "greener" or "more sustainable" than they were, a practice known as "greenwashing."

With the global capital markets placing increasing value on companies’ Environmental, Social, and Governance (ESG) risks and performance metrics, various agencies have been developing multiple rating systems. Some rating systems are performance-based, while others are risk- and/ or disclosures-based. Corporates and agencies, however, are still trying to decipher these ratings and their algorithms.

An ESG score aims to gauge a company's performance on ESG issues and exposure to ESG-related risks. The score is typically calculated against a set of metrics and may be expressed on a number scale or through a letter ranking system. While comprehensive rating methods are being worked out, ESG ratings can help companies manage sustainability-related risks or opportunities and provide a structured framework to approach corporate sustainability initiatives.

Though the popularity of ESG ratings has accelerated significantly over the past few years, so has the cynicism — primarily due to lack of complete transparency & knowledge — around their merit in driving rational investment decisions. Some label ESG ratings as a system fraught with subjective methodology; others point toward its incapacity to predict and integrate ESG signals into a final score on a near/real-time basis. Some territories are even viewing ESG ratings as a Greenwashing on select parameters.

Data is the king, but challenges remain!

Though the importance of data in ESG investing can’t be debated, corporates need more transparency to make the right choices. Here are some of the emerging challenges related to ESG performance benchmarking & ratings:

Garbage in, garbage out: Driven by corporate reporting standards and the different taxonomies and methodologies used by data providers, the quality and consistency of ESG data is currently the biggest challenge.

Like other investment strategies, the “garbage in, garbage out” concept also applies to green investing. Stakeholders and investors demand baseline, standardised data to support relevance, objectivity and comparability. However, at present, they are receiving fragmented data from multiple sources, such as company reports, news articles, vendors and rating agencies. In order to put an end to greenwashing and enable investors to make informed, precise and transparent decisions, ESG data integration must evolve quickly.

ESG reporting needs to mature and have the same rigour and relevance as financial disclosures so that investors can understand the economic impact of ESG strategies and targets.

Lack of transparency in data aggregation: Understanding data inputs, assumptions and limitations are essential to understanding results. For example, some rating firms “overweight” particular ESG themes. Enterprise will need to determine whether these themes are material for them. Some rating firms also calibrate their score with sentiment analysis, while others do not.

Lack of correlation between ESG scores: With investors trying to compare like-for-like, data consistency is another big challenge. There is an argument that standardisation of scoring methodologies is not always appropriate since different enterprises will face different materiality of risk.

Lack of available ESG data: This is a major challenge for both data providers and evaluators. There is disparity across industries, with better quality data available for higher carbon sectors, such as oil and gas, and a lack of data for other sectors, such as agriculture and forestry. The latter have not been focusing heavily on CO2 output, but they must work to catch up in this new landscape. Data sets for less material sectors are being developed but are still immature.

Another challenge is to ascribe a score based on the past year’s performance while making sense of long-term commitments from companies that state their intent to become net-zero by 2050.

This is a brave new world, and newer systems and organisations are merging to form the International Sustainability Standards Board (ISSB), which might bring more clarity. The Securities and Exchange Board of India (SEBI) is pushing companies toward greater disclosure in India and plans to keep a close eye on ESG ratings.

Greater and open disclosure will be the key to building a new and transparent world.

Nitesh Mehrotra is Business Consulting ESG Partner (ESG Governance, Process & Digitization Lead) at EY India and Damandeep Singh Ahluwaliais Climate Change and Sustainability Services Associate Partner at EY India.

Disclaimer: The opinions expressed by the author/interviewee do not necessarily reflect the views of Business Insider India. The article has been partly edited for length and clarity.

This column is part of June 2022’s month-long awareness campaign on the theme “Only One Earth: Sustaining People, Planet and Prosperity” by Business Insider India’s Sustainability Insider.