Why are ESG controversies so controversial & what can companies do about them?
Controversies – or news items related to perceived ESG missteps are part of the ESG data and scores provided by ESG rating agencies. While due diligence on ESG ratings information can be monitored by companies, controversies are often more difficult to tackle and are also at risk of being mismanaged, either because they are overlooked, or on the contrary, because they are misunderstood. Their influence on a company’s overall ESG rating and potential impact in terms of company reputation and investability, should be carefully considered by companies. Below we explore the controversies element of ESG ratings and provide company guidance for how to address them through the implementation of an ESG ratings and controversies management plan.
For the growing universe of institutional investors integrating Environmental, Social and Governance (ESG) aspects in their investment decisions, monitoring sustainability related data from their investee companies is crucial. It allows them to tilt their portfolios and increase capital allocation to companies with perceived lower ESG risk and identify those being able to capture the sustainability-related opportunities. This has recently been reinforced by regulation on investors themselves, particularly in Europe.
The EU’s Sustainable Finance Disclosure Regulation (SFDR) has made mandatory for investors that market funds with an overarching ESG mandate to report on a number of principle adverse indicators (PAIs) which include human rights and biodiversity negative impacts, among many others.
Similarly, investors are well aware of the potential reputational risk of investments in controversial business activities, typically those echoed by the media, which can turn into high-profile cases such as the Diesel Emissions Scandal  or the Brumandinho Dam Disaster . Alongside ESG data, ESG-related media stories on thousands of listed companies are collected by ESG ratings agencies and data providers, such as MSCI, Sustainalytics, S&P ESG, ISS and Moody’s ESG (Vigeo Eiris) among others.
ESG controversies are collected in real time by these ESG rating agencies, filtered through and rated based on their respective methodologies to assess their potential impact to a company, its share price, business outlook, and in turn, the tangible and reputational impact on investment portfolios. This results in a quick turnaround and usually relevant ESG news making it to the various ESG ratings products within days from publication by the media.
What are ESG controversies and how are they scored?
Controversies are scored by rating agencies based on their perceived severity or impact to society and also based on a company’s response. Severity is often scored on a scale from “very severe” to “minor” depending on various factors such as number of people impacted, land area impacted, the length of time over which the impact occurs, fines, and ultimately, the reputational risk to the company and the rating agencies’ clients’ investment portfolios.
Sensitivity to media stories vary. Some controversy cases are instantly deemed severe or very severe if it impacts a vulnerable group of people (such as indigenous people) and/or protected environments (such as an oil spill in a conservation area).
Agency methodologies are dynamic and evolve over time. The table below gives a high-level summary of some of the leading ESG rating agencies and their approaches to scoring ESG controversies:
Table: ESG Controversies Approaches by leading providers
(Click to expand)
How do investors use controversies scores?
From an investment perspective, having these items flagged are an important component of a company’s ESG evaluation process as they provide useful and up-to-date context potentially underlying governance or operational flaws in a company. Many institutional investors, including some well-known large asset managers such as BlackRock, State Street Global Advisors and T.Rowe Price, monitor controversies collected by ESG rating agencies to assess potential risks, prioritise engagement with companies and inform their proxy voting decisions. If engagement is pursued, in the worst-case scenario, the outcome can potentially trigger a divestment decision by some of those investment funds, depending on their mandates, and as such, the impact of ESG controversies goes beyond a simple rating. This also applies to passive investments as many ESG indices consider controversy ratings for index inclusion (such as the MSCI ESG Leaders Index).
While the impact of ESG controversies cannot be understated, there are actions that companies can take to mitigate them.
How should companies monitor and address these controversies?
Given the importance of investors’ access to company controversy listings, companies could benefit from having a controversies management plan in place. Companies should first identify the most impactful ESG ratings providers among their investors and monitor their online portals and reports on a regular basis, including the controversies collected. When a controversy has been identified by an agency, oftentimes the immediate reaction by companies may be to rush a rebuttal response. However, this is not always the best approach. Careful consideration should be given to evaluating if all the relevant facts surrounding a given event and any company press releases associated to provide investors, its clients, have been provided. Because the controversy item in the portal may already include how a company is responding to a given event, no additional feedback may be necessary.
In other cases, providing relevant feedback would be advisable. Some listed controversies may contain incorrect facts or could be missing key information, in which case, should be sought to be corrected by the company through providing factual evidence where needed. In these cases, companies would do well taking some time to liaise with internal subject matter experts (such as legal or governance teams) to collect all the relevant facts and prepare a cohesive well-put-together response. Not only can this result in a descaling of the controversy severity, but it can also help to resolve a controversy and potentially have it archived.
Having a specific point person or team responsible for monitoring ESG rating agency accuracy, including controversies is a useful way to help ensure consistent monitoring and communication. In terms of who should coordinate controversies’ responses, having a team/individual responsible works best. In many cases, the Sustainability team, or alternatively the Corporate Communications or Investor Relations teams, are best placed to manage communication with ESG rating agencies, including ESG controversies.
What are the challenges for companies in dealing with ESG controversies?
As with ESG Ratings in general, the ESG controversies approaches by leading providers table highlights key differences between agencies. Simply put, what is considered as a controversy by one agency, may not be by another, and severity grading also varies. It is also often unclear the impact of a controversy on the overall company ESG score. This can be problematic for both companies and investors. In addition, investors will often have their own filters and analysis performed upon the data.
Companies often disagree with the severity assigned to a case and find it hard to influence a change. Although agencies have tools to collect company feedback, the process still leaves them in charge and severity levels often remain unchanged for long periods of time. Given the unregulated status of these ESG ratings activities, the only alternative left for companies in this scenario is to seek to engage with the ESG rating agency and try to establish additional independent sources that can support the company response, including the appointment of an independent auditor in extreme cases. As a result, engagement can be a lengthy and a costly process.
At Leaders Arena we have a dedicated team of ESG analysts who support companies’ efforts to monitor, verify and respond to ESG ratings and controversies. Please see our ESG ratings webpage and brochure for more information on our services!