RIP to ESG Ratings: Unveiling ESG’s Hidden Truths

In this episode “Debunking ESG Myths“, we scrutinize the ESG ratings industry, which is currently under intense scrutiny. With lawsuits, discontinuations, and discrepancies among ratings providers, it’s clear that the system needs improvement. Sasha sheds light on the industry’s challenges and offers insights into how ratings can better reflect a company’s sustainability and business model. Discover the evolution of ESG ratings, the need for forward-looking data, and how Rimm Sustainability is changing the game by linking ESG metrics to financial targets and real-world impact. Don’t miss this candid conversation that uncovers the true potential of ESG ratings and their role in shaping a sustainable future!

Discussion Topics: Unveiling ESG’s Hidden Truths

• Is the ESG Industry Under Scrutiny Today?
• How Did ESG Ratings Come Into Existence?
• Why ESG Ratings Today Tell Us Very Little About ESG
• Construction of an ESG Rating
• Is There Room for Improvement?
• Changing the ESG Rating Game
• Future for ESG Ratings
• Pathway Towards a Better World
• How Will Local Ratings Evolve?

Transcript: Unveiling ESG’s Hidden Truths

Ravi Chidambaram: Hello everyone. Welcome to ESG MythBusters, a podcast where we debunk, demystify and deconstruct some key ESG preconceptions with unfiltered knowledge and data from key experts in the field. I’m Ravi Chidambaram, CEO, and founder of RIMM Sustainability. An impact driven SaaS company that advocates for making sustainability accessible and actionable to all through our data and other ESG applications. In this episode, we are very happy to have Sasha Beic as our guest. Sasha is a very distinguished ESG investor with a very long track record in history at various institutions like Sine Nordea Bank, amongst others. He also has a very popular blog called ESG on Sundays, which has over 30,000 readers and more recently a very popular ESG radio show where he also has guests and has attracted many views.

So Sasha also has a very close link to us at RIMM. He’s a special advisor for data analytics and applications. As we hope to drive more meaningful insights and data analytics to our clients. Sasha, great to have you on the show.

Sasja Beslik: Thank you very much.

Ravi Chidambaram: It’s all about people and it’s all about action. So maybe we could just kick it off. We get right to it. Okay, then. Good ESG ratings are having a moment, but a not-very-good moment. We read everywhere about lawsuits filed by clients. To around ESG rating providers and misleading scores and not portraying them in an accurate light.

We hear about s and p discontinuing numeric ratings as part of their credit product. And I think a lot of other ratings providers are under a lot of heat to explain their methodologies, sources of data, and so on. We’ve seen the famous ft chart that shows there’s no correlation between different rating providers and the ratings they provide on the same companies. So it’s fair to say that this is an industry under scrutiny today. Can you tell us what is your candid view on the state of the ESG ratings industry and the methodologies and analytics used today?

Is the ESG Industry Under Scrutiny Today?

Sasja Beslik: Thanks, Ravi. I think the first thing is that the ESG rating industry is not regulated. So in principle, you have this variety of players on the global market that will come up with their own methodologies to rate. Particularly one part of the business and that is what I call the conduct part.

So what kind of policies do you have, what kind of processes do you have? So companies are rated on the basis of what they say about themselves in terms of the internal processes and internal sort of conduct. They’re not rated on the basis of what they produce, they sell in terms of what kind of business they run.

And this has been a heel of ratings for, I would say last 10, 15 years, and going back when they started, I. The financial industry always looks for solutions where you can get a more sort of simplified or quick view of a company from an ESG perspective. And of course, at the time when they developed the entire sort of a rating structure an entire way of how they’re done was taking a sort of a grip on the conduct side, the processes side you have right policies. Do you have, a human rights due diligence process, are you describing it in the right way?

So if you look at the rating space, I think what is interesting is that you have so many AAA-rated companies. If we use the analogy of triple, credit ratings like the three A’s two A and so on. And still, we have a situation where the two emissions in industries and sectors are going up for the very companies that are top-rated.

So there’s a disconnect. So what is the challenge? I think the challenge is that these ratings need to be transformed. I think the conduct part will still be there. But they need to be transformed into ratings of how sustainable the business model of the company really is. And this will require another type of analysis, another type of data.

And that is something that is, I think, what is happening at RIMM as well. What we are trying to do is to get the data to actually reflect the business model of the company and how this is aligned with their financial targets in relation to the products and services.

Ravi Chidambaram: Thanks, Sasha. Yep, absolutely. Can you maybe educate the audience a little bit on how ESG ratings came into existence?

How Did ESG Ratings Come Into Existence?

Ravi Chidambaram: When I started doing this back in 2003, it’s a long time ago now. We had what was called the ethical or SSRI. So socially responsible investment type of things. Since that part of the sort of investment universe was growing, the investors needed more and more sort of accurate information in order to make investment decisions that would not be in line with their expectations the asset owners had.

So it’s an asset owner-driven thing. Asset managers themselves are not really, initially, were not drivers of these kinds of ratings. They were followers. So the asset owner industry was pushing the envelope in terms of putting the requirements to avoid certain things.

Sasja Beslik: So it started with exclusions. So you exclude companies that are in certain sectors. Tobacco, alcohol, weapons, I don’t know, pornography, and so on. And then it evolved into developing the ratings that will.

Capture, I think the core of the conduct of the company, if they have the right governance system in place to manage their risk, and the ratings were used initially for the information, but then later on, many investors will use ratings to basically separate parts of the universe that they would like to invest or not invest.

So they will create, just to give you an example, so back in, I think 2000, between 2006 and 2000 and. Eight before the crash you had a lot of best-in-class approaches. What it means is that you will put the sort of, you will take the ratings outta the universe that you’re looking at, and then you will put all the rating companies in one section and then you will go with that section to your portfolio manager and you will say, this is your best in class universe. This is what you’re investing in. So this was the way of, so it’s a way of risk management,

And then after 2008, there were a couple of years of dwelling on what was going to happen. But then back in 2010 when the market took up, again, ratings were starting to be used, as a tool. One of the tools to integrate ESG into your mainstream is a way of thinking.

So we went from the best-in-class exclusion thing into integration. An integration part is, the part that is actually most interesting is how you, in your investment process when you’re making investment decisions, how you take in ESG as the supporter of your investment case or thesis. And how do you inform your investment decision by, in the information that is provided by these ratings?

So you would have different cuts and skews in this. When I was working at Noea, we had products that were thematic. We had the best-in-class products, we had integrated products. We had different kinds of them, depending on what kind of clients you had. And nowadays I think ratings by themselves are in many cases just used as an indicator.

For the asset managers. Depending on how big you are and how much capacity and resources you have, many are still using ratings as a way to say to the clients that we have, we are using one of the big providers they’re providing this data. This data is integrated into the way we invest.

Based on that, we are clean, we have a third-party data provider that is going to change and it’s going to change very quickly going forward.

Ravi Chidambaram: Yeah. That’s great. But to go Tick tick and use that as a proxy for sustainable kind of performance and not linking it into their core business. So that really explains in some ways why ESG ratings today really tell us very little about ESG.

Why ESG Ratings Today Tell Us Very Little About ESG

Sasja Beslik: You have this very strange situation where you look at the company from a rating point of view on ESG, but then you have a completely different discussion on the financial targets and the growth targets of the company and the products and services.

So these two things are completely disconnected and, how are you gonna make an investment decision? There is another thing on the ratings that I didn’t mention, which is very important. All of the ratings today around the world, most of them, I think 99%. Is based on backward-looking information.

And they’re usually annually one, one year late because the companies produce the reports, quite late on sustainability. Now there is some kind of integrated reports with school integrated, but in general, they are not, they’re not accurate because they’re not relevant, because they’re backward-looking. You are, you’re making investment decisions forward. So it’s, that’s also part of the problem.

Ravi Chidambaram: Yep. To all of our listeners, I hope you’re enjoying our conversation today with Sasha Beic. I encourage all of you to sign up and subscribe to the show. And I think more often than not, we’ll always have interesting guests and continue dissecting various myths around ESG. Let’s carry on Sasha’s ESG ratings. Tell us how they’re put together. How is a typical ESG rating constructed?

Construction of an ESG

Sasja Beslik: Sure. So in principle, most of the rating agencies are providing a sector-based approach. So you will have a methodology that outlines what the sector risks on E, S, and G, which are relevant, and material from a conduct point of view for a particular sector, and I’m making that emphasis all the time from a conduct point of view.

What kind of is this industry prone to supply chain management risk in terms of child labour or forced labour? Okay, tick. Now we know that this is a sector risk, and we’re gonna check if all companies in the sector have policies in place to address that risk.

In that, in the next section do they have evidence? Is there evidence that they’re following up on their policy? That’s sort of what this kind of a thing does on the environmental side is this part of the, is this sector c or two intensive in terms of the energy use and production that becomes part of the sector materiality?

Then basically you map companies against, so what this, the ratings are constructed from underlying methodology where the sector risks and ratings on the. ESG risks are specified. Then companies, company information is run basically through that as a filter. And then on the other side, what you get is you get an understanding of Company X compared to the peers in that particular sector is better or worse from a set of K P I indicators that are specific for that sector.

That’s basically how they’re constructed. And the only information that is used to construct these ratings is public information produced by companies, as I said, backward-looking the year before. Usually there is in some instances you can find information that is related to reputational risk if a company has been involved in controversies and so on. But in general, that’s how the ratings are constructed.

Ravi Chidambaram: Yeah. So now taking that apart and deconstructing it there are so many aspects there, right? So where are the areas within the existing scoring approach? Do you think there’s room for improvement?

Is There Room for Improvement?

Sasja Beslik: The current ESG ratings are just half of the story. So they are 50% of the full rating. And the full rating will be a combination of your conduct rating. Do you have the right things in place?

Do you address sector risks from the right perspective? Do you have information to support that? And the second. Part, which is the other 15%, is, how you grow your business. What are your products and services? How true are, how true is materiality in terms of your risks and your sort of business?

And that part is what I think needs to be developed. And this is what we are doing at RIMM as well to try to see how we can link and find this centre of gravity, true materiality between the conduct and the product and service and the growth projections of the business.

Ravi Chidambaram: Yeah, that’s a good segue actually into question three. You’ve been one of our key advisors in building our data analytics capability and making more sense of scoring and making it more meaningful, both for asset managers as well as companies to use. I think at the core like any good economist you would view ESG as a set of externalities, and those externalities will clearly affect the P and L production process ultimately it shows up in the financials but it’s all about business processes and so on. Can you tell us how using that sort of externality approach, RIMM is trying to change the game on ESG ratings?

Changing the ESG Rating Game

Sasja Beslik: I think the approach and the latest sort of development we’ve done to develop a true materiality model, with different parts of that model basically focusing on the clear link or finding the link or identifying the financial value of the ESG issues that are. Having financial support for the company to reach the target.

So in principle, what we are looking at is that we are looking at the financial targets for the company growth projections, expected growth, and so on. We are then looking at the ESG strategy of the company and the targets they’ve set on the ESG side to see, okay, what’s the alignment or misalignment of that?

And then underlying that is the cost drivers for the particular sector where you look at the way, how is this reflected in a sector? So just to give you an example, you have a company that has a target to be carbon neutral by 2030. They’re gonna do it, they’re gonna grow their business double. They’re gonna a hundred percent grow their business until 2030. At the same time, they want to take down their emissions by 50%.

And then what we are, what we can, what we are able to tell investors is how credible it is. Is it really doable? What’s wrong with this approach? How much it’s probably gonna cost them to do that? These are the things that the investment community really needs because the investment community does not have at this stage.

Really good understanding of what the climate target or net zero targets or any kind of a climate-related sort of pledge. What does it actually mean in the financial terms for the company? Are they gonna make money, lose money, they’re gonna stay steady? What exactly does it mean? So what we are looking at is to provide a completely new view where you link these two sorts of areas together.

Ravi Chidambaram: Yeah, and I think that goes to the heart of incorporating and integrating externalities into the daily. Business processes of these companies and by extension their numbers. that you can unravel so many shortcomings with the current rating system, right?

Because greenwashing is addressed. And whether there’s any harmonisation between ESG targets and financial targets. We long felt that ESG targets were always cooked up in a corner office somewhere by the C S R people. Whereas the real work gets done, in the C-suite with the finance and CEO guy.

Sasja Beslik: Even the discussion with the companies becomes completely different because instead of approaching the ESG as a sort of a static, static risk management, PR, marketing, green wall, whatever, exercise. You actually have a discussion with the company, about what in the ESG space that they’re doing and what strengths they have, can they use to grow their business in a sustainable way.

I think that’s the other beauty of these ESG ratings, as you pointed out earlier, were really the domain of investors. To the extent, investors engage with their portfolio companies, tools like true materiality are actually a very powerful tool to do that because it goes to the heart of it.

Ravi Chidambaram: But conversely, it’s also a great tool for companies themselves to manage their ESG targets and goals and reconcile them with their financial goals.

Sasja Beslik: When you have discussions both with investors and with the companies, if you go to a company and you ask, okay what is the centre of gravity of ESG work in your company? What exactly, are the sort of trigger points for your financial performance on this?

They usually don’t have an idea because they haven’t been looking at this from that perspective. But then you go to the investment community and say, okay what is in this portfolio or this particular investment, what are the sort of financial links to Ishi? And then you realise that, okay, but here again, there is a disconnect.

We haven’t been looking at the companies from that perspective. There’s a lot to be done, but I think we are advancing the approach and methodology, and I think it’s going to be interesting to see how we can deploy this, on, on a global scale going forward.

Ravi Chidambaram: Yes. I’m very eager to see how that goes. We’re getting close to the end. I hope that you’ve enjoyed the discussion so far. Dear listeners. And I want to close out with some very important final questions for Sasha One, Sasha, and ESG ratings. What does the future hold, do you think?

Future for ESG Ratings

Ravi Chidambaram: I think, as it looks today, I’m talking specifically about Europe. I think that it’s inevitable that part of the ratings will be regulated now, just as, that’s a speculation from my side because we have an EU taxonomy. And we have S F D R on the other side. The natural step would be that you have part of the ESG ratings, a part of the e-regulated because you have actually legislation that supports you to do that.

Sasja Beslik: So that is the sort of a discussion that I think it’s going to happen, and it’s happening right now. So you may have. Part of the ESG rating that is regulated, will be a regulated part, which is related to two emissions in particular. The more you regulate on the c o two or the parts of the e, inevitably this will become the financial value.

Yeah, and in some ways the EU is integrating, the compliance with the rating, right? So the EU taxonomy and disclosing, CapEx in sustainable investments, percentage of revenues that’s sustainable and so on is working very much towards that. Compliance is moving away from just a report.

However, because the EU regulates disclosure. They’re not telling you what to do. They’re just saying, this is what you need to tell us. But if that is the, if they are regulating that basically what they’re hoping to achieve is that the underlying mechanism changes as well. And that will come from the investment side.

And let me ask you this. ESG ratings primarily have been used by, the investment community as you pointed out, but yet it seems to me ESG ratings may be more useful for the actual companies themselves, as you pointed out, as they engage on key ESG subjects.

This is so interesting because I meet a lot of companies on a regular basis, and when you ask them, do you know about, what’s the central gravity of your competitors on the ESG side, what they’re good at, what they’re bad at? Has anybody done analysis on your own business from the outside? I

They would usually say, we get some report from some of the rating agencies, but we don’t understand it and it’s not related. In many cases, it’s not even our sector. So you have this need on the business side to really understand, and I think it’s, as you say, point out that it’s much more useful, I think, for the companies to determine where they are and what they need to do.

Ravi Chidambaram: Yeah, especially so because it seems like ESG ratings for investors will always be subjective and in the eye of the beholder, whereas for companies, it seems to be far more true, far more objective, and a company could get a more honest glimpse into that, right? Because I think no matter how you try to standardise and regulate rating, For investors and the investment community, will all have different strategies and approaches ultimately to what they invest in and how they view ESG and so on.

Sasja Beslik: Exactly.

Ravi Chidambaram: Yeah, so that’s a really interesting point because that’s not at all how a lot of people look at ESG ratings today. So in a way that is like maybe the eureka moment in today’s conversation, and I think a lot of people really don’t appreciate that many of the ratings providers provide ratings for the investment community.

And ignore the underlying i e the companies themselves. And, that’s the pathway, right? Towards a better world and a more sustainable world. Ultimately it’s on the companies to improve.

Pathway Towards a Better World

Sasja Beslik: I also think it’s another thing to add. Companies need to understand what they’re rated on and why, and also what are the sort of a, what’s the point of this? Because I meet Japanese companies, I meet European companies that will tell me, we are AAA company. And this is a very recent discussion I had with the CEO of a company in Japan.

We are a triple AAA-rated company, but we don’t get any pay for this. I’m looking at him saying, what do you mean? So we are best, but we are not getting anything on a stock sort of a stock price. It’s not affecting our stock price. But then when I explained that, this rating is done on your, on how they conduct their business, not about their products and services, then he was, he had this eureka moment as well.

Ravi Chidambaram: I think that’s the other big takeaway from today’s conversation. Maybe one final thought to close. Local ratings Will, ratings o as they evolve, will they be a one size fits all type model? I. Or as we see in the credit market, where domestic capital markets are driven more by local ratings and international issuance is governed more by international ratings like SS and P and Moody’s. How do you see that evolving in, in ESG?

How Will Local Ratings Evolve?

Sasja Beslik: Look, the big parts of the world have been excluded from the ESG universe, investment universe because they cannot comply with the Anglo-Saxon approach of, let’s say this disclosure, transparency reporting. They’re punished, they’re discriminated against.

And this is going to create, and I think the future is much more local and much more regional because there are different development levels in the different markets and there is different maturity, but there are also different issues. The issues that you have, you will have in Sweden Japan or Switzerland are different from what you will have in Indonesia Malaysia, and some other parts of Africa or South America.

And this is, I think, part of the development of the entire e space too, to add business and products and services, but also a local angle to, how do you look at the companies.

Ravi Chidambaram: Yeah. To just close out on that. So for example, in your view in Japan, they would refer more to local policies and regulations and cultural practices and use things like the new corporate governance code or their legal code or other legislation to drive the evaluation of Japanese companies rather than just rely on standard factors, set out by the international agencies.

Sasja Beslik: So you have, Japanese companies that are generally punished on the governance side because their view on board composition and longevity of the board is different from the Western Anglo-Saxon approach in Asia and Japan in particular.

If you have, if you’re older and have experience and you’re sitting on a board for a long time, it’s seen as a good thing because you can contribute in a completely different way. We have a different view of the Anglo-Saxon world, we think it’s, you are becoming too stuck. You are, you conflict, there’s a lot of conflict interest and blah, blah, blah, and all these other things.

So the Japanese, if you look at the average, the Japanese companies are heavily punished on the governance side. Which is in the context they operate in Japan. not outside Japan, It doesn’t make any difference for them if they, if they’re gonna improve their board diversity or independent board tenure and all of that.

Just to fulfill the requirements of the Anglo-Saxon investors when they truly operate only in Japan and have that kind of a need to have that kind of board composition. They have. I think this is an example of how it is done in a completely wrong way.

Ravi Chidambaram: and the need for local ratings. The other one, the good one is related party transactions. Of course, in Asia with the TSU system and the family business system, there’ll be a lot of related party trans transactions, but they don’t, It doesn’t mean they’re corrupt, it just means it’s a normal way of doing business. And it serves them well. But again, in the Western model of ratings that probably would be a red flag.

Sasja Beslik: It is, and this will need to change because I also think it doesn’t make any difference for the, the entire point of what we’re doing with Impact and ESG investments is to create a tangible difference on the ground for people, communities, for society in general. These ratings need to reflect what needs to be done on a local level.

Yeah, no, thanks, Sasha. Let me wrap up the discussion by summarising some of the key points. There was a lot that we got through. Number one the origin of the ESG rating industry very much, was investor-centric and investor-driven. As Sasha very rightly pointed out, a lot of the ESG ratings were derived from conduct.

Ravi Chidambaram: I. Rather than actions in the business. So having policies, and having certain committees in place were valued more over how ESG externalities were attacked in the business and the daily provision of business and products and services basically that I think we can say is increasingly discredited both amongst companies and the investor community.

Partly because there’s no common ground of how these ratings were constructed, and the ratings were constructed really only in one dimension around conduct rather than actions. So that automatically tends to discredit them in many ways the industry. Leaving aside things like the reliance on unaudited, self-reported data and so on.

Sasha has been working very hard. To come up with a new and far more detailed and insightful rating system. Really driven around the true materiality approach. The true materiality approach tries to harmonise a company’s ESG goals and its financial goals and tries to understand what it means for the business, what it means for the balance sheet income statement, and tries to reconcile those two things to really see.

Whether companies are practising good ESG or not. Going forward this will have more value to companies rather than investors and companies, as Sasha said, are the pathway to improving communities, improving lives, and creating true impact, which is what the whole ESG movement was about in the first place.

Thank you, Ravi. And what we all need to think about is that we need tangible change. We need action, and we need to make sure that companies actually transform their business models. I think they want to do that, but they also need help on the road.

Absolutely. With that call to action, I want to thank all the listeners for joining us today in busting more ESG myths. We hope you gained some key insights. More importantly, I found a new perspective. Thank you again, Sasha. We’ll see everyone in two weeks to bust our next myth.

Keep listening. Keep signing up. Thanks.

Our Guest: Sasja Beslik 

Sasja Beslik is a Swedish and international financial expert known for promoting financial sustainability across the world. Sasja has helped catalyze the rise of ESG investing in Europe and the world and is a recognized thought leader and practitioner in this space. The Stars fund he launched with Nordea in 2011 helped pioneer sustainable investment in Europe and was awarded Sweden’s outstanding equity fund in 2017. His funds have consistently beaten the market while achieving significant sustainability results for the listed companies. Sasja was awarded a medal from His Majesty the King of Sweden for outstanding contribution to the environment and sustainability (2016), and he was recognized as a Young Global Leader at the World Economic Forum (2011).