Here’s how to make ESG ratings true indicators of sustainability

At present, the ESG ratings landscape looks like the Wild West. Unregulated and opaque. Major polluters are getting high ESG scores despite their poor track record. Companies obtain very different scores according to different rating agencies. An increasingly concentrated market is dominated by just a handful of predominantly US players.

The European Commission itself supported two major studies on the ESG rating markets, including one by Blackrock. The conclusions are clear: lack of transparency, comparability, major divergences, and conflicts of interest are widespread. 

This is especially striking in the transport sector. Large polluting companies with slow decarbonisation pathways obtain disturbingly high ratings. Despite being among the biggest CO2 emitters in the world, companies like Toyota or Scania score incredibly high on environmental grounds according to major ESG raters’ assessments. And this is because they massively underweight their lifetime emissions. 

Why does this matter? Despite all these flaws, ESG ratings are too often mistakenly believed to be indicators of sustainability. In fact, while their primary goal should be to evaluate companies based on their sustainability performance, they do not provide a complete and accurate picture.

In practice, the majority of existing ESG ratings predominantly focus on assessing companies’ “financial materiality” – their financial risks deriving from ESG factors – while neglecting the wider impact they have on people and the environment.

Moreover, this assessment often occurs through a peer-to-peer comparison, disregarding the companies’ absolute performance in relation to science-based targets. So oil and gas majors can get away with high scores simply if they behave a little bit better than their competitors. 

All these flaws result in a distorted evaluation, misleading investors and thus preventing companies that are actually making a positive impact on E, S and G from getting the recognition and financing they deserve. 

This is particularly problematic as ESG ratings strongly influence and drive private investments that are necessary to accelerate the green transition. The EU needs to take steps to change this. The Commission proposed back in July a first-ever attempt to regulate the ESG ratings market in Europe.

It should bring increased transparency, a stronger governance and supervision framework and provisions to counter conflicts of interest.

However, it fails to ensure the quality of ESG ratings. What is the point of increased transparency – knowing how ratings have been elaborated – if they still don’t provide a meaningful picture of the sustainability of a company? We believe that to be reliable indicators they should, at least, assess double materiality and clearly split the score between E, S and G. 

This is where elected representatives of European citizens need to make the difference. The European Parliament has a unique opportunity to make ESG ratings true sustainability ratings.

With the upcoming EU elections, the rush to close files and the ongoing wave of anti-green legislation, one may think this is an unfortunate time for negotiations. Still, fixing ESG ratings is one of the last possibilities under this mandate to complement the EU Sustainable Finance strategy. It holds the potential to connect the dots between other legislation asking companies and investors to disclose more data about their operations, like the EU Taxonomy. 

This is a crucial missing piece in the European Green Deal. Trustful ESG ratings won’t fix the climate crisis by themselves, they’re not a silver bullet. But they should finally become an instrument to steer capital flows towards the most sustainable companies and the ones transitioning the quickest.