10 Things ESG Scores Can (and can’t) Do For Investors

This article was originally published in Equities.com on August 27, 2024.

One major question mark facing the sustainable investing world over the next few years, is what, if anything, should be done concerning the use of the acronym ESG.

Sentiments range from divisive to disappointing, but to those in financial services it is abundantly clear that environmental, social and governance (ESG) data is essential to fully understand the sustainability, ethical practices, and long-term viability of companies, helping to find potentially fatal flaws that traditional financial analysis previously failed to diagnose.

ESG data can help investors identify potentially problematic companies, long before traditional valuation methods would pick up on the issue. For instance, MSCI flagged many ESG-related risks with Equifax EFX a whole year before the company disclosed a data breach that compromised the privacy of millions of Americans and simultaneously lost investors billions of dollars.

Additionally, prior to BP’s disastrous Deepwater Horizon oil spill in 2010, ESG data providers pointed to multiple instances of severe controversies involving employee safety that the company refused to address.

It is fortunate that more companies have taken measures to disclose sustainability-related matters in their annual reports to shareholders — either by choice or by circumstance. According to the Center for Audit Quality, 98% of the companies in the S&P 500 reported ESG information in 2022 and of those that reported, 70% obtained assurance over some ESG information, up from just 65% in 2021.

While the efforts for assurance by these companies are commendable, it is critical that an extra set of eyeballs examines the ESG data published by corporations because investors have indicated that they still do not trust the original sources.

A 2023 Global Investor Survey from PricewaterhouseCoopers showed that 94% of investors believe that corporate reporting contains at least some level of unsupported claims of sustainability and 85% of investors think that companies’ disclosures of ESG metrics should be assured at the same level as their financial audits.

ESG data is clearly important, however most investors and financial professionals simply do not have the time to play detective in determining what ESG data will, or could, have a financial impact on which investments.

This is why both now and in the future there is an imperative need for high-quality research from third-party ESG data providers.

At their most critical function, ESG data providers will take raw ESG data and through a combination of industry best-practices, generally accepted industry standards and proprietary practices create an ESG rating or score, meant to provide a snapshot in time an organization’s overall ESG risk and/or impact in a concise and simple manner.

In the absence of a global standard regarding ESG scores, or even what specifically constitutes material ESG data, there is a lot of misinformation and misunderstanding over the usefulness and reliability of ESG scores.

Regardless of their variance by provider, ESG scores provide a comprehensive way not only to evaluate and compare companies’ sustainability and ethical performance, but they also offer valuable insights for investors, consumers, other companies, regulators and many other stakeholders.

Let’s clear up some of these most basic misconceptions.

10 things that ESG scores can do

1. Help with investment analysis and decisions – ESG scores help to find investments that align with investor values and sustainability goals, at the same time providing long-term returns. Additionally, ESG scores can help to mitigate long-term ESG risks.
2. Benchmarking and comparison – examining ESG scores over time can help identify leaders and laggards among companies in the same industry.
3. Corporate strategy and improvement – companies can use their ESG scores to identify areas for improvement in sustainability and governance practices.
4. Regulatory compliance and reporting – they provide a clear way to communicate ESG performance to regulators and stakeholders.
5. Shareholder communication and engagement – scores can be used to assure sustainability commitment to shareholders and provide a way to showcase ESG engagement over time.
6. Risk mitigation – can help highlight potential ESG risks and encourage companies to be proactive about managing them.
7. Market differentiation and competitive advantage – companies with high ESG scores can differentiate themselves from competitors, touting brand loyalty and trust.
8. Operational efficiency and cost savings – ESG scores help to identify companies with quality sustainable practices to reduce waste and energy consumption.
9. Employee attraction and retention – companies that treat employees fairly tend to have higher ESG scores, thus they are becoming used as part of job searches.
10. Innovation and product development – the use of ESG scores in general is helping to advance the ways in which sustainable products and services are developed not only in investments, but across many industries.

10 things that ESG scores cannot do

1. Predict short-term financial performance – ESG scores align with long-term risk management rather than forecasting short-term financial gains. They are not used by short sellers or investors looking to turn a profit quickly.
2. Provide a complete risk assessment – ESG risks are not the only risks inherent with companies, they are simply one piece of the puzzle.
3. Ensure accuracy and consistency – scores are only as high quality as the underlying data, which can vary significantly by company and region. Also, a lack of universal standards in ESG reporting can lead to inconsistencies and changes in comparing scores between different providers.
4. Capture all aspects of corporate performance – ESG scores do not provide a full picture of a company’s health or profitability.
5. Account for subjective judgments – there can be biases among some aspects of scoring depending on certain qualitative factors.
6. Predict future ESG performance – ESG scores are based on past and present data and cannot predict the future; they are a snapshot in time.
7. Assess impact on broader systemic issues – while ESG scores only look at individual companies, broader macro issues like climate change, social inequality or economic stability may still affect how those same companies function, regardless of their scores.
8. Provide granular insights into the company – contrarily, there may be in-depth analysis of specific issues within each ESG category that is still lacking when looking at individual companies.
9. Give assurance of ethical behavior – ESG scores can only be based on what is publicly available at any given time, and therefore there is no guarantee that a company is actually acting with integrity. The scores can only highlight reported practices and policies.
10. Directly influence consumer behavior – while ESG scores may be helpful to some consumers in making more socially conscious decisions, there is currently not noticeable impact on a broad scale.

ESG scores should always be used in conjunction with other tools and analyses for the most comprehensive evaluation of a company’s financial risk and performance.

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