The ESG rating approach to measuring the environmental and societal impact of firms, whereby they are measured and ranked on the consolidated parameters of Environmental Stewardship, Social Inclusion, and Good Governance, is of relatively recent origin, with the concept having been launched in a pathbreaking report sponsored by the UN Global Compact in the year 2004. A perfect storm of external factors, – ranging from the increasingly palpable and worrying symptoms of climate change, to community-led agitations against the errant ways of big business, have motivated firms to undertake fundamental transformation journeys towards ESG compliance. This process has been hastened by tighter regulatory scrutiny worldwide, as well as by investor demands tied to mitigating the environmental and societal impact risk by, and consequently on, firms.
Compliance around ESG parameters has thus become an existential requirement for many companies worldwide, for ensuring better access to investor funding, for reducing regulatory and societal risk, as well as for better branding and access to new markets. Attaining respectable ESG scores and profiles are now increasingly vital for ensuring the sustainable growth of firms, particularly in terms of access to impact-investing funds, which have currently invested more than 30 trillion dollars in ESG assets.
Head – Government & Public Services
KPMG in India
On the regulatory front, India has also introduced new compliance and reporting protocols, with the Securities and Exchange Board of India’s (SEBI) Business Responsibility and Sustainability Reporting (BRSR) requirements becoming mandatory for the top 1000 listed Indian firms by market capitalization from this financial year on, for ensuring better-calibrated reporting, as well as greater data transparency for investors and the public.
While ESG investing, reporting, and rating enterprises are still at an evolutionary stage, they have spawned a whole new industry: there are currently around 600 agencies worldwide that rate firm performance, utilizing a variety of frameworks, with consequential challenges around data complexity and comparability. While a number of initiatives are underway to standardize the ESG rating ecosystem, led by entities like the World Economic Forum and the International Sustainability Standards Reporting Board, this looks set to be a long and complex task, given their current diversity, and the variety of approaches used.
The ESG reporting and rating industry has been put somewhat on the defensive, after being assailed by a variety of recent critiques. There are basic concerns around data quality, with rating measures being considerably reliant on data that is self-reported by companies, and with the majority of data points being oriented towards internal compliance procedures, instead of measuring actual performance on ground. Moreover, different agencies use different methodologies as well as varying indicators for rating, again compounded by ascribing differing weights to measure similar indicators. Another challenge is that ESG measures particularly around aspects like social impact are not easily quantifiable, hence extra care needs to be taken to reduce perception bias. The quality of data used also varies widely across geographies and countries. As a consequence, the ratings used by different agencies tally less than half the time, unlike financial ratings, where the ratings accorded by different agencies tend to be much better aligned.
The larger challenge around reporting and rating stems from the difficulty of comparing apples and oranges – Environmental Stewardship, Social Impact, and Good Governance factors inhabit different worlds, therefore tying them all together into a compound metric tends to make the exercise imprecise and somewhat subjective.
Merging these three completely different attributes into a single compound index has led to consequences that are questionable, like an oil giant being rated among the top ten best in the world on ESG parameters by Standard and Poor’s Dow Jones Sustainability Indices, while a globally leading firm in electric vehicles, which has been a pioneer in transitioning to renewable energy, was struck off on account of challenges around their social and governance parameters. Thus, a firm that led the world in terms of pathbreaking measures to reduce the world’s carbon footprint finds itself out of the ESG rankings, an outcome that is hard to digest from a commonsensical viewpoint.
Given the increasingly visible evidence of climate change, particularly of alarming changes in weather patterns worldwide, the rationale for firms to mitigate their environmental impact has never been more compelling. Perhaps the time has come to unweave the ESG bundle, and to standardize and separate out environmental impact measures alone, from the S and G aspects. The environmental metric is already complex enough, including as it does a wide variety of factors that need to be mastered for firms to reduce their carbon footprint and pollution impacts. Moreover, the social and governance axes call for action in a different dimension, demanding totally different approaches, though some of those could help progress the journey towards environmental goodness also.
The time has perhaps come to take a fresh look at this entire approach and playbook. Imagine how much better things would be if we had a unified, clear, and universally accepted set of yardsticks to measure the impact that firms and institutions make on our physical environment.
Authored by
Elias George, Head – Government & Public Services KPMG in India.
Edited & sourced by: Queenie Nair, ET Edge Insights
