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In America and Europe some politicians, bosses and investors want to shift away from measuring corporate performance based mainly on shareholder returns. Climate change is another catalyst. Christine Lagarde, the new head of the European Central Bank, thinks the institution should consider using monetary policy and bank supervision to fight climate change—a shift that would involve assessing which firms are dirtier than others. Mark Carney, the governor of the Bank of England, has championed better disclosures by firms on climate change. Chris Hohn, the head of TCI, a London-based hedge fund famous for its hard-headed approach, has outlined plans to vote against the directors of companies that fail to reveal their carbon emissions.
All this is fuelling demand for ESG ratings, which create a single score from disparate non-financial indicators, such as a firm’s carbon emissions or the share of its board members who are female. Using teams of analysts, whizzy software and data from companies, ratings firms collect ESG information and convert it into a single score. Some customers of ESG ratings are seeking to gain an investment edge; others want their money to benefit society as well as themselves. But the ratings are not yet ready for the weight they are being asked to bear.
The most obvious sign of this is that, unlike credit ratings, ESG scores are poorly correlated with each other. ESG-rating firms disagree about which companies are good or bad. Moreover, ratings are often based on business models rather than businesses themselves. It does not matter what firms are selling, as long as it is done sustainably. The scoring systems sometimes measure the wrong things and rely on patchy, out-of-date figures.
One hope is that the boom raises standards. Bigger firms are getting involved, which could help. On November 21st S&P Global, a credit-rating agency, bought the ESG arm of RobecoSAM, an asset manager. Moody’s, a competitor, purchased Vigeo Eiris, an ESG data outfit, in April. In 2017 Morningstar, a research firm, acquired a 40% stake in Sustainalytics, another ESG rater. MSCI, an index provider, has been building up its ESG-scoring expertise. Simon MacMahon of Sustainalytics expects scoring systems to converge over time. The definition of ESG is so broad, he says, that raters may be trying to capture different things.
If ESG data do eventually become more accurate and consistent it will become harder for bosses and fund managers to engage in “greenwashing”—massaging indicators without truly changing hue. And investors will be able to pursue more varied and sophisticated ESG targets, says Maria Elena Drew of T. Rowe Price, an asset manager. Big insurers, for example, which are heavily exposed to extreme weather events, will be able to invest their capital in a way that hedges against climate risks. But for now the ESG rating industry is still in its infancy.