ESG investing is great, but it needs a better scoring system

The growth in environmental, social, and governance (ESG) investing is undeniable. Arguably, it is the most important investing trend in years—one that allows investors to incorporate their values in their investment decisions without sacrificing performance, according to a growing body of research. As is the case with any new trend, those serving investors—investment banks, money managers, credit rating agencies, data firms—have rushed in, looking to establish a foothold in ESG’s developing market structure as it matures and mainstreams.

One of ESG’s growing pains is a lack of consensus around what constitutes a favorable or unfavorable ESG score. We at Kroll Bond Rating Agency (KBRA) attribute some of that to the lack of standardization in terms of company disclosure. Interested parties such as the International Financial Reporting Standards Foundation, the Sustainability Accounting Standards Board, and the Task Force on Climate-Related Financial Disclosures are hard at work developing common disclosure standards, and we support those efforts.

Quantifying ESG factors against agreed-upon standards will establish important benchmarks that will aid investors, company managers, and regulators in their quest to evaluate firms and assets. Improved disclosure will also work to reduce “greenwashing” abuses, wherein companies overhype their commitment to ESG goals to attract investors.

However, it is imperative to note that we do not believe investors are well served by credit rating agencies that muddy the waters by connecting ESG scoring systems with credit ratings. Not only does ESG scoring involve subjective, values-based criteria, it also confuses investors and issuers looking for clarity on both but finding neither. We also believe it has the potential to raise conflicts of interest between the two, while straying beyond the regulated mandate under which credit rating agencies operate.

True consensus on ESG favorability will remain elusive for the simple fact that the other half of the equation, values-based criteria, is by its very nature subjective. When considering the rise in ESG scoring, SEC Commissioner Hester Peirce in 2019 warned of “labeling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric.”

Is an arms manufacturer a defender of democracy or a warmonger? Is a full-spectrum consumer lender providing a lifeline to the unbanked or imposing a financially harmful burden? These are questions that only investors can answer.

As a global credit rating agency, KBRA never loses sight of what we are—credit analysts. To that end, we are well aware that ESG factors can rise to the level of being influential in determining an obligation’s creditworthiness.

It is our philosophy that credit rating agencies should not pass moral judgment on a factor that may happen to register under any one particular investor’s ESG filter, but rather, assess more broadly how management is responding to the rise in ESG sensitivity, be it on the part of capital providers, customers, regulators, or policymakers. Those constituents, and their specific ESG interests, can affect the company’s cost of capital, demand for its goods or services, risk of litigation, or unfavorable regulation. Any of those things can be material, positively or negatively, to that company’s credit rating.

In addition, we believe evaluating how companies manage ESG’s impact should be part of a dynamic, forward-looking review process, rather than a static assessment at any one point in time. Risks, ESG or otherwise, need to be actively managed. While we are interested in how those risks may have arisen, our ratings need to reflect how those risks will develop in the future and what management’s plan is in terms of mitigating or capitalizing on those risks.

The way we see it, one of the ways to pull together the impact of factors as disparate as E, S, and G is to recognize that they are all a function of “M”—management—something that sits at the heart of our credit analysis. Evaluating how a firm manages its risks and opportunities is a critical piece to truly forward-looking ratings. Sustainability, defined in this case by the impact of ESG, among other factors, is an essential element that contributes to that view.

Assessing management’s effectiveness in not only identifying but mitigating and capitalizing on sustainability trends captures the influence of these factors in a clear and concise manner—and that is something that we believe serves investors well, ESG-oriented or otherwise.

Jim Nadler is president and CEO of KBRA.