MIT Sloan Review: Why Sustainability Ratings Matter

MIT Sloan's Management Review recently ran a thoughtful piece on "Why Sustainability Ratings Matter" by Dr. Allen White, the venerable co-founder of the Global Reporting Initiative. Dr. White's thesis is that rating, ranking and indexing organizational performance on so-called "ESG" or environmental, social, and governance matters is a pre-requisite to providing investors with investment-critical information otherwise absent in traditional financial disclosures.

By rating, ranking and indexing issue-specific and multi-issue composite performance, ESG ratings provide a proxy for a company's external costs and benefits absent from conventional financial accounting and reporting systems. - Dr. Allen White

Dr. White couldn't be more right. But his warning that these ratings are only useful when "they are credible, transparent and timely" should serve as a powerful broadside to the current state of ESG disclosure, which is patently everything but credible (self-reported, un-validated  data), transparent (non-public results and scoring methodologies) or timely (annual, at best). Here's the highlights from Dr. White's important piece on sustainability rating, rankings and indexes.

Pervasive

  • 50,000 companies annually subjected to ESG evaluations by more than 80 research and ratings organizations worldwide.
  • 400 products offered by the global corporate ratings industry.

The large and growing number of companies subject to some type of ESG evaluation reflects the rapid pace of innovation and acceptance in sustainability credentialing. The bloated number of ratings products signals an absence of generally accepted standards that are comparable to those governing corporate financial and sustainability reporting.

Persistent

Communications technology, big data and globalized markets make ratings a ubiquitous feature of international commerce. Investors, tenants, and consumers live in this always-on information environment. Dyanamic ratings, like LEED's Dynamic Plaque, seek to fill to holes in previous "set and forget" ratings that, upon further examination, didn't live up to their loft goals (or claims). One annual report card is no longer sufficient to effectively communicate sustainability efforts and current performance to stakeholders.

Powerful

  • Sustainability ratings are an indispensable tool for business-to-business and business-to-consumer exchanges.
  • Ratings serve as a powerful efficiency enhancer but only when certain conditions are met. Specifically, they must be: credible, transparent, timely.

Rating, Ranking and Indexing... So What?

  • Ratings provide a proxy for a company's external costs and benefits absent conventional financial accounting and reporting systems.
  • They inform capital providers with critical information to distinguish firms that outperform their peers in terms of risk management and corporate governance.
  • Good ratings should, in theory, highlight good management by identifying companies that exhibit management acumen, resiliency in the face of regulatory uncertainty about carbon, and other ESG risks.

Positive Externalities

ESG leaders can expect to be rewarded with lower-cost of capital, an especially attractive advantage for firms that frequently use bonds to finance factory, infrastructure and equipment purchases.

The growing body of research linking strong sustainability performance with strong financial performance only improves the value proposition for sustainable business practices. - Dr. Allen White

  • Rapid growth of ESG-based investing, now estimated at $21 trillion of ESG assets under management worldwide.
  • Strong financial performance only improves the value proposition for sustainable business practices.
  • A study of 2,300 companies by George Serafeim and his colleagues at Harvard Business School, for example, found that companies with good performance on material ESG issues demonstrate stronger stock performance than those with weak performance on the same material measures.

barriers to best practice

  1. The absence of independent, impartial guidance as to which ratings adhere to a standard of excellence creates unnecessary friction in the ESG information supply chain.
  2. Lack of impartial assessment of data sources, quality controls, conflicts of interest and other critical attributes of high-quality products.
  3. Government regulation needs to mature to include ESG to mirror regulations around fixed income securities that require high credit ratings.

Read more at MIT Sloan Management Review...

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