Why ESG ratings don’t work yet

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Two years ago, researchers at the University of Chicago Booth School of Business started collecting data to determine the real social and environmental credentials of companies in the S&P 500.

One of their goals was to pull back the curtain on the murky world of metrics used to set ESG scores, an increasingly fraught arena for investors seeking greenwashing-free data. What they found was that companies generally received higher marks (there's a growing number of research firms focused on ESG ratings) based not on performance, but rather the number of metrics they disclosed. And to make matters worse, the lack of full transparency across industries makes it difficult to see any company's ESG ranking in context.

For example, some ESG disclosures by utilities were robust. The industry provided statements on company websites listing the most metrics on workforce diversity compared with other sectors. The problem was that the industry performed poorly. A closer look showed utilities ranked second to last in the percentage of female workers employed, according to the study, which was based on an analysis of 2017 corporate social responsibility (CSR) reports.

As for within industries, the lack of universal, comparable disclosure makes internal rankings less than reliable.

"While the number of CSR reports has been increasing, there still isn't mandatory disclosures, which makes comparing companies' performance difficult," said Shirley Lu, who has a doctorate in accounting from Booth and was part of the three-person team that compiled the study.

Lu and her colleagues focused their research on CSR reports published by S&P 500 companies to pinpoint the most commonly disclosed metrics and then used those details to compare relative performance by various industries. The report was compiled in conjunction with Jingwei Maggie Li and Salma Nassar of the business school's Rustandy Center for Social Sector Innovation.

In the end, the team gathered 69 metrics to assess companies' social and environmental records. The social bracket included four subcategories: diversity, safety, community engagement and suppliers. The environmental data was narrowed to five items: greenhouse gases, energy, waste, water, and accidents and fines. The exercise was somewhat constrained because only 65% of the companies in the S&P 500 issued a CSR report for 2017.

Among their other notable findings were:

The insurance industry provided the fewest details about greenhouse gas emissions, as well as energy, water and waste consumption.
The computer industry was one of the biggest consumers of energy—just after petroleum, natural gas and chemical companies.
Food producers were some of the largest consumers of water.
The business supplies industry, which includes companies like International Paper and 3M, placed among the top emitters of Scope 1 greenhouse gases (direct emissions from the company's facilities).

On the social side of the ledger, the retail industry reported having the largest percentage of female employees and apparel companies had the highest percentage of minority employees. As for community engagement, the pharmaceutical industry reported making big donations, led by Merck & Co. and Johnson & Johnson.

But having researchers dig around CSR reports for nuggets of actionable insight is far from a successful strategy for universal ESG rankings.

"The metrics aren't an end point—they should be a starting point," Lu said. "They should be used by investors to ask questions about what's behind the numbers."

Sustainable finance in brief

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