It’s time to give businesses self-sustaining climate assessments

Investors are increasingly using ESG ratings for their investment decisions. But we need to assign companies a standalone rating focused on climate risk, separate from the ESG rating system. Such a climate-specific rating can distill complex information about a company’s carbon footprint and climate risk into an intuitive and user-friendly format, while avoiding the flaws that currently plague ESG ratings. The “super-nasty” problem of climate change is so urgent and far-reaching that it deserves its own rating, one that avoids the methodological complexities and legal challenges of merging E, S, and G. climate-specific C rating would allow investors and executives to make the climate-conscious choices that markets tell us they want.

Environmental, social and governance (ESG) ratings have clearly captured the market’s attention. In 2021, more than $120 billion was invested in sustainable investments, more than double the $51 billion recorded for 2020. When it comes to climate change, however, ESG ratings are an imperfect vehicle for conveying relevant information for investors. Instead, we need to assign companies a stand-alone rating focused on climate risk. Such a climate-specific rating can distill complex information about a company’s carbon footprint and climate risk into an intuitive and user-friendly format, while avoiding the flaws that currently plague ESG ratings.

One of the main flaws of ESG ratings is the differences in definition and methodology between rating agencies. Take the example of Tesla Motors, the world’s leading manufacturer of electric vehicles. With the electrification of transportation widely hailed as the cornerstone of global strategies to reduce air pollution, reduce greenhouse gas emissions and mitigate climate change, one would expect Tesla to get the minus the environmental component of ESG ratings. Indeed, MSCI’s ESG Index has already ranked Tesla at the top of the automotive industry. At the same time, however, the FTSE rated Tesla’s environmental performance at “zero”, ranking the automaker behind oil and gas giant ExxonMobil in terms of sustainability. These and other inconsistencies in ESG ratings not only confuse investors seeking advice, but more generally threaten to erode popular trust in the ESG concept itself. (Tesla CEO Elon Musk made a similar point last week.)

The creation of the International Sustainability Standards Board (ISSB) at the UN COP26 last November prompts cautious optimism about the harmonization of ESG standards. But the process will likely take years, based on the experience of the International Accounting Standards Board (IASB), on 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 because few investors bother to decode a company’s ESG score into its constituent parts. This leaves a majority of investors unsure of what exactly is driving a company’s below-average ESG rating. Is it, for example, the product of modest underperformance in 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 place the same value on the environmental, social and governance aspects grouped under the ESG umbrella. Of course, many environmentally conscious investors also have a social agenda. And both categories have potential overlap with governance issues. But, given a more granular metric, many investors would prioritize certain ESG aspects over others. In fact, a look at recent trends in shareholder activism, often with a particular focus on climate change, suggests that the “E” in ESG might deserve to be bolded.

A recent poll indicates that two out of three Americans are worried about global warming. Stand-alone climate ratings recognize this widespread concern and help investors assess, at a glance, climate risk exposure and management for their investment objectives. To be clear, not all companies have a large carbon footprint or face serious climate risks. But therein lies the value proposition of specialized climate ratings. Without the added complexity of other environmental metrics, let alone social and governance, investors can more easily determine whether a given asset’s climate rating matches their investment strategy and preferences.

The best part? We have good reason to believe that climate ratings can, indeed, facilitate more climate-aware asset allocation in financial markets.

In a recent article, we reported empirical evidence of the impact of climate ratings on investor decision-making. Through a series of survey experiments, with over 1,500 participants, we found that including climate ratings among the performance measures commonly considered by investors significantly increases investment in the stocks of companies with favorable climate ratings, even though other competing stocks have a higher yield. profile. The inclusion of a generically labeled climate score, for example, boosted investment in the most climate-friendly stocks by more than 20% compared to the control scenario.

This effect of climate ratings was even stronger for ratings formulated in terms of a company’s vulnerability to climate change, channeling more than 50% of incremental investments into the most climate-resilient stocks. 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 highlight the importance of communicating climate risk in a format that speaks to investors.

Finally, climate ratings can help overcome legal hurdles imposed on asset managers of pension funds, charitable trusts and other institutions subject to US trust law. Apart from the special rules for charities and the authorization of the settlor or beneficiary in personal trusts, the single interest rule of the law on trust trusts requires that these asset managers maximize the bottom line . The collateral benefits of ESG investing, such as fairer governance, do not meet this profit maximization requirement. But asset management based on weather ratings is likely to succeed, given the well-established impact of physical and transient weather risks on a company’s bottom line. It’s no coincidence that the California Public Employees’ Retirement System (CalPERS) announces its sustainable investing program as a strategy to “minimize the absolute risk of climate change to our portfolio.”

To be clear, we support ESG ratings. Indeed, we believe they have a vital role to play in promoting more sustainable investment and corporate governance, especially when reporting and rating become more standardized. But the “super-nasty” problem of climate change is so urgent and far-reaching that it deserves its own rating, one that avoids the methodological complexities and legal challenges of merging E, S, and G. “Climate-specific” C rating would empower investors and executives to make the climate-conscious choices markets tell us they want.

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