Why Sustainability Ratings Matter

Were you rated recently? If you used Uber to get to work, stayed in an Airbnb, or opened a new line of credit, the answer is most certainly “yes.” The answer also is “yes” if you happen to work for one of the 50,000 companies annually subject to environmental, social and/or governance (ESG) evaluations by more than 80 research and ratings organizations worldwide.

The convergence of communications technology, big data and globalized markets make ratings a ubiquitous feature of international commerce and an indispensable tool for business-to-business and business-to-consumer exchange. When they are credible, transparent and timely, ratings serve as a powerful efficiency enhancer in a fast-moving global economy.

For companies, rigorous ESG ratings can play a vital role in benchmarking and driving improvement across a wide spectrum of issues: energy efficiency and carbon reduction; occupational health and safety and human rights; board diversity and quality of sustainability strategy. 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.

In so doing, they equip capital providers with critical information to distinguish firms that are superior to their peers in terms of risk management and corporate governance. It also helps in identifying those companies that exhibit management acumen in terms of resiliency in the face of regulatory uncertainty about carbon control, living-wage laws and other ESG factors. Companies that demonstrate ESG leadership can expect to be rewarded with lower-cost capital, an especially attractive advantage for firms that frequently float bonds to finance large factory, infrastructure and equipment purchases.

Companies may be subject to ESG performance evaluations from some 400 products offered by the global corporate ratings industry. This large and diverse range of products reflects both the pace of innovation in the field and the absence of generally accepted standards that are comparable to those governing corporate financial and sustainability reporting. Further contributing to this expansion is the rapid growth of ESG-based investing, now estimated at $21 trillion of ESG assets under management worldwide. As water use, fair advertising, stranded carbon assets and other ESG issues are increasingly recognized as material to investment decision-making, the need and opportunity for trusted and transparent ESG ratings will continue intensify.

The growing body of research linking strong sustainability performance with strong financial performance only improves the value proposition for sustainable business practices. A recent 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. These results are consistent with other studies that should sway even the strongest ESG skeptics that ESG investments pay for themselves many times over.

Can we expect growth in the ESG ratings market to accelerate in the coming years? At least three barriers stand in the way, though all are surmountable. First, thousands of rated companies, attentive to the reputational and competitive consequences of ESG ratings, receive a multitude of annual rater questionnaires. 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. Generally recognized principles for identifying such excellence would provide a compass for companies to discern the most credible ratings among the many seeking data inputs via questionnaires to their organizations.

Second, investors would benefit from an independent, impartial assessment of data sources, quality controls, conflicts of interest and other critical attributes of high-quality products. This would go a long way toward building the demand for ESG ratings in financial markets.

Third, government regulation of agencies such as Moody’s and S&P set in motion a trend among institutional investors to limit their fixed-income securities to those that assigned a high credit rating. Learning from the far more mature field of credit ratings, one may envision a future in which a similar form of regulation is applied to ESG ratings, an action that almost certainly fuel a substantial expansion of the ESG ratings market well beyond its current level.

A decade ago, these same conditions characterized the kindred field of corporate sustainability reporting. Today, such reporting has been transformed from the exceptional to the expected business practice for large corporations in all regions of the world. Beginning with the Global Reporting Initiative and followed by the Sustainability Accounting Standards Board and the International Integrated Reporting Council, as well as initiatives such as the Carbon Disclosure Project, sustainability reporting is now widely seen as an essential element of responsible business conduct.

As the next step in the sustainability value stream, ESG ratings are positioned to repeat the rapid rise of sustainability reporting. Companies will benefit from trusted ratings that recognize and reward true performance excellence. A virtuous circle fueled by growth in both supply and demand promises to propel this trajectory. At scale, ESG ratings promise to make a major contribution to the biggest prize of all — building companies and financial markets that align with the ever-more-urgent global sustainability agenda.