The Need to Set Industry Standards for ESG Ratings
A call to action has been issued to correct the discrepancies in ESG scoring. Industry leaders should take a proactive approach in remedying the current rating system by setting their own industry specific standards.
The fledgling Environmental, Social, and Governance field is beginning the long and arduous process of creating universal standards. Investors are leading the charge and demanding more transparency to make informed decisions.
Although the concept of value-based investing has been around for a while, ESG investing is a modernized, multifaceted approach that helps investors to identify risks. The effectiveness of the ESG framework is dependent upon investors having access to reliable and comprehensive data.
A downside of the United States being slow to adopt ESG principles is that regulations and standards requiring the disclosure of this information is lacking. While the U.S. Securities and Exchange Commission (SEC) has recently proposed regulations, industry leaders should take a proactive stance and set their own industry specific standards.
Setting ESG Standards in the Housing Sector
Green Builder Media is taking on the initiative with the creation of a working group to address Environmental, Social, and Governance issues. Housing sector experts such as the Housing Innovation Alliance, Energy & Environmental Building Alliance (EEBA), and several other organizations will work as a collective to identify key metrics and indicators for reporting.
The creation of standards can be used as an opportunity by experts to collectively decide what criteria is most appropriate for their field rather than wait for a regulatory authority to dictate generalized standards.
For example, the home building industry is known for being resource intensive and as such emphasizes the environmental aspects of ESG more than the other two pillars.
The prioritization of one pillar can be detrimental to a company’s ranking. Therefore, within the housing sector, experts should advocate for environmental standards to be weighed more than social or governance standards to achieve a more accurate ranking.
Discrepancies in Scores
The current method for rating and ranking a company’s use of an ESG framework is highly variable. Many of the top rating agencies rely on the quantity of disclosures a company submits rather than the quality of those reports. This is an unfortunate consequence of the U.S. having voluntary ESG disclosures.
In addition, ESG rating agencies follow a policy-based approach rather than an outcome-based approach. This is problematic because companies can write well written policies to increase their ranking without having to implement those policies. For instance, a company that pledges to plant 1 million trees could be ranked the same or higher than a company who completed their commitment to plant 1 million trees.
A company’s stock can become volatile after a discrepancy in their score provided by the various ESG rating agencies. These discrepancies can be attributed to three factors: scope, measurement, and weight.
Scope is the number of criteria that the ESG rating agencies use for their evaluation. If one rating agency evaluates companies using 10-criterion but another rating agency uses 20-criterion, discrepancies in scores are likely to occur.
Measurement is the number one contributing factor to ESG score discrepancies. For instance, all rating agencies might evaluate for sustainability but use different indicators to measure for that criterion. The use of different indicators can dramatically change a company’s score among rating agencies.
A difference in the way that each criterion is weighted can also lead to discrepancies in ESG score. The variability in scoring cannot be fixed unless universal standards on scope, measurement, and weight are adopted for each industry.
KB Home has experienced firsthand the volatility of ESG scoring. For example, through Refinitiv, KB Home has an excellent score of 76 and ranks 13 out of the 165 home building companies. While S & P Global has given KB Home a poor ESG score of 39. A discrepancy of this magnitude can scare away potential investors and emphasizes the unreliable nature of scoring.
Although the ESG rankings may seem arbitrary, 76% of the top asset managers use two or more ESG data and ranking providers to make investment decisions. A call to action has been issued to remedy the broken rating system. Unfortunately, since the field is still in its infancy, a mandated solution is not on the horizon.
Companies of all ESG levels can benefit from incorporating technology early in their management planning process. ESG software streamlines the data collection and analysis process to create better disclosures.
Stay tuned for the next post in the ESG blog series explaining the importance of ESG software. We invite you to join our team of industry experts as we identify key ESG metrics, develop baselines, explore reporting and SEC climate risk disclosure requirements, and craft strategies for continuous improvement.