Investors are using ESG ratings for their investment decisions. But we need to assign companies a stand-alone rating focused on climate risk that’s distinct from the ESG rating system. Such a climate-specific rating can distill complex information regarding a company’s carbon footprint and climate risk into an intuitive, user-friendly format, while avoiding the flaws that currently mar ESG ratings. The “super-wicked” problem of climate change is so urgent and far reaching that it deserves its own rating, one that eschews the methodological complexities and legal challenges of melding together E and S and G. A climate-specific “C-rating” would empower investors and c-suites alike to make the climate-conscious choices that markets are telling us they want.
Environmental, Social, and Governance (ESG) ratings have clearly caught the market’s attention. In 2021, over $120 billion poured into sustainable investments, more than double the $51 billion logged for 2020. When it comes to climate change, however, ESG ratings are an imperfect vehicle to convey investor-relevant information. Instead, we need to assign companies a stand-alone rating focused on climate risk. Such a climate-specific rating can distill complex information regarding a company’s carbon footprint and climate risk into an intuitive, user-friendly format, while avoiding the flaws that currently mar ESG ratings.
One prominent flaws of ESG ratings lies in the definitional and methodological variations across rating agencies. Consider the example of Tesla Motors, the world’s leading manufacturer of electric vehicles. With transport electrification widely hailed as a cornerstone of global strategies to alleviate air pollution, reduce greenhouse gas emissions and mitigate climate change, one might expect Tesla to ace at least the environmental component of ESG ratings. Sure enough, MSCI’s ESG index has previously rated Tesla at the top of the auto industry. At the same time, however, FTSE rated Tesla’s environmental performance at “zero,” ranking the carmaker behind oil-and-gas major ExxonMobil in terms of sustainability. These and other inconsistencies across ESG ratings not only confuse investors searching for guidance but, more generally, threaten to erode popular faith in the ESG concept itself. (Tesla CEO Elon Musk made a similar argument last week.)
Creation of the International Sustainability Standards Board (ISSB) at the United Nations COP26 last November gives cause for alarmed optimism that ESG standards may one day become harmonized. But the process will likely take years, based on the experience of the International Accounting Standards Board (IASB), after which the ISSB is modeled.
Even if ESG reporting and rating are eventually harmonized, they will remain a multi-faceted construct that seeks to mold environmental, social, and governance factors into a single metric. Along the way, critical granularity is lost as a few investors bother to decode a company’s ESG score into its constituent elements. That leaves a majority of investors unsure what exactly is driving a company’s subpar ESG rating. Is it, for example, the product of modest underperformance across all three categories or the result of decent scores in two categories but exceptionally poor performance in the third? The possible permutations are too many to list here but you get the picture.
This lack of granularity is problematic because not all investors assign equal value to the environmental, social, and governance aspects merged under the ESG umbrella. Sure, many environmentally minded investors also have a social agenda. And both categories have potential overlap with governance questions. But, given a more granular metric, many investors would prioritize some ESG aspects over others. In fact, a look at recent shareholder activism trends, often with a specific focus on climate change, suggests that the “E” in ESG might deserve to be boldfaced.
Recent polling indicates that two in three Americans are worried about global warming. Stand-alone climate ratings acknowledge this widespread concern and help investors gauge, at a glance, the exposure to and management of climate risk for their investment targets. To be clear, not all companies feature a large carbon footprint or face serious climate risk. But therein lies the value proposition of specialized climate ratings. Without the added complexity of other environmental, let alone social and governance metrics, investors can more easily determine whether a given asset’s climate rating fits their investment strategy and preferences.
The best part? We have good reason to believe that climate ratings can, indeed, facilitate a more climate-conscious asset allocation on financial markets.
In a recent article, we reported empirical evidence for the impact of climate ratings on investor decision-making. Through a series of survey experiments, with over 1,500 participants, we found that inclusion of climate ratings among the performance metrics commonly considered by investors significantly increases investment in the stock of companies with favorable climate ratings, even as other, competing stocks feature a stronger return profile. The inclusion of a generically labeled climate rating, for example, boosted investment in the more climate-friendly stock by over 20 percent compared with the control scenario.
This climate ratings effect was even stronger for ratings framed in terms of a company’s vulnerability to climate change, channeling over 50 percent of additional investment toward the most climate-resilient stock. For both ratings, the effect is statistically significant and holds after controlling for investor characteristics, such as age, education, income, political views, financial literacy, and other demographic factors. Our results not only confirm the impact of climate ratings on investor decision-making; They also underscore the importance of communicating climate risk in a format that speaks to investors.
Climate ratings, finally, can help overcome legal barriers imposed on the asset managers of pension funds, charitable trusts, and other institutions subject to US trust law. Outside of special rules for charities and authorization by the settlor or beneficiary in personal trusts, the sole interest rule of fiduciary trust law requires these asset managers to maximize the bottom line. Collateral benefits from ESG investment, such as more equitable governance, do not meet this profit-maximization requirement. But asset management based on climate ratings is likely to pass muster, given the well-established impact of both physical and transitional climate risks on a company’s bottom line. It is no coincidence that the California Public Employees’ Retirement System (CalPERS) advertises its Sustainable Investments Program as a strategy to “minimize the absolute risk from climate change to our portfolio.”
To be clear, we support ESG ratings. Indeed, we are convinced that they have an integral part to play in promoting more sustainable investment and corporate governance, especially once reporting and rating have become more standardized. But the “super-wicked” problem of climate change is so urgent and far reaching that it deserves its own rating, one that eschews the methodological complexities and legal challenges of melding together E and S and G. A climate-specific “C-rating” “would empower investors and c-suites alike to make the climate-conscious choices that markets are telling us they want.