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How to measure ESG performance

How to measure ESG performance

ESG criteria have risen to the top of the list for investors and other stakeholder groups alike, but is it possible for an organisation to reliably quantify its ESG performance?

The importance of measuring ESG performance

2020 has been a year of unprecedented chaos – witnessing an international public health crisis, global economies thrown into recession, civil unrest, and popular movements driving change. But nonetheless, a continuous theme has run throughout. In spite of, and in some cases due to, the disruptions brought about by coronavirus, the focus on sustainability and ethical issues has continued to sharpen.

Longstanding concerns around environmental, social, and governance (ESG) issues, covering everything from the use of palm oil and size of carbon footprints to workers’ rights and executive pay, have not dissipated. They have fused with the issues arising out of Covid-19 and the Black Lives Matter movement to fuel demands by consumers, NGOs, communities and the media for companies to do – and be seen to be doing – the right thing.

This trend is reflected in the growth of ethical investing, which is not only popular with companies’ many external stakeholders, but also their shareholders. Proactive investing towards sustainable goals has a positive impact on both corporate reputation and financial performance, recognised by capital markets and asset management companies alike. Investment analysis now has an ESG focus.

All of which makes it imperative for organisations of all sizes, in all sectors, to proactively monitor their ESG profile as part of their risk management strategy. By doing so, they can identify emerging ESG-related risks before they become material, while also capitalising on their positions on specific ESG considerations, in order to present themselves as leaders in those fields.

The evolution of ESG measurement

ESG performance is a growing consideration in company valuations. In a business environment where sustainability and ethical impact are central to survival, businesses can use ESG criteria to assess their non-financial performance. But in an area composed of so many elements, encompassing everything from parental leave and diversity policies to in-house recycling and supply chain relationships, measurement is not a simple discipline.

The evolution of ESG performance measurement has seen the condensing of independent ratings systems, out-of-date filings and sporadic press coverage. The overall picture of performance has been based on voluntary company self-disclosures alongside mandatory company disclosures. Signing up to the UN’s Sustainable Development Goals, for example, places an onus on corporations to meet specific ESG criteria.

In an attempt to more accurately quantify ESG position, various ESG ratings systems have emerged. Designed to separate the most-consistent sustainability performers from the haphazardly well-meaning, ESG ratings rank companies against ESG criteria, valuing their performance on a sustainability scale. Using annual reports, media coverage, investment analytics and management data, and factoring in exposure to ESG risk, a numeric score is produced as a proxy of ESG performance.

No single gold standard exists for ESG ratings, which are reliant on the robustness of the data used, and vary in consistency between industries, regions and size of business. To date, they are at best subjective, and at worst, misleading, creating significant challenges for executives, investors, consumers and campaigners seeking to evaluate a business by its ESG credentials.

The challenges to ESG measurement

Which leads us to the challenges with, and flaws in, the current measurement processes. While the concept of an ESG profile is both valued and broadly understood by many organisations, the ability to link it to tangible outcomes is often lacking, undermining its full potential. This is largely due to inconsistencies in measuring it, and lack of a single, recognised methodology.

Perhaps the biggest hurdle is the breadth of issues packed into the ESG acronym. Covering off every social, governmental and environmental action, intention, and impact of an organisation, ESG offers a near-infinite checklist. As yet, a single definition is lacking. Even for a sole organisation within an individual sector, totting up every ESG liability becomes extremely complex. And the size of the field simultaneously opens companies up to backdoor risk if they fail to consider all relevant ESG elements.

The need for a weighting system adds another layer of complexity. Different stakeholders have very different priorities within the overall ESG package. Shareholders will be looking for companies with profitable longevity. Consumers for a clean conscience when they use products and services. Employees for a company that aligns with their goals and values. This might variously mean adherence to carbon emissions limits to avoid hefty fines; a transparent promotion scheme; or reduction in plastic packaging. Which stakeholder group’s needs should be prioritised when evaluating ESG ratings?

The opacity of many scoring systems makes any weighting hard to ascertain, and leaves them open to accusations of arbitrary rankings. This is exacerbated by a lack of industry standard, making different systems impossible to fairly compare. In addition, the data being used to evaluate adherence to ESG goals is inconsistent and open to dispute. Relying on self-disclosure by companies means understanding what they are willing to report or not. Where there is a legal requirement for disclosure, such as for the gender pay gap in large companies, data is easier to compare, but still prone to inconsistencies, and limited in scope.

Timing is another issue. Without real-time reporting being factored in, and consequent adjustment of rankings, a company could continue to score highly after a suffering an ESG crisis. The lack of traceability of source material in the current systems throws further doubt on their veracity.

Added to all of this is the lack of standard measurement across various industries. Different sectors are prone to different ESG risks and opportunities, and any system of measurement needs to take this into account. The airline industry, for example, with its emissions issues, fossil fuel consumption and recent bad press over mass redundancies post-Covid has a very different ESG risk profile to the agricultural sector, with its vulnerability to criticism over soil erosion, pesticide use and animal welfare.

The solution: ESG intelligence

What is needed, therefore, is an objective, reliable system of scoring that can accurately, consistently assess how different stakeholders perceive a company’s ESG credentials – and represent those credentials in a useful way. Accurate monitoring of ESG risk such as this will enable companies to identify, and rectify, negative issues that are gaining traction; and leverage areas where they are doing well.

This level of insight goes beyond ESG rankings into the realm of ESG intelligence. An effective system will encompass the daily, and even real-time, analysis of millions of pieces of publically-available print, online, broadcast and social media content – including traditional news reporting, blogs, user reviews, and, vitally, regulatory disclosures and NGO communications – to render an ESG score. This will allow relevant, up-to-the-moment benchmarking of companies’ ESG liability.

To provide further robustness, the scores should be indexed against a benchmark such as the Sustainability Accounting Standards Board (SASB) standard taxonomy.

In order to analyse the sentiment contained in tens of thousands of news sources and millions of individual pieces of online content across many geographies and in multiple languages, ESG intelligence requires the use of machine learning and natural language processing (NLP) technology, combined with knowledgeable human oversight. Scoring should also incorporate volume of coverage, share of voice, influence of the source and prominence of the issue.

The next stage in the evolution of ESG performance measurement, this breed of solution will provide reliable scoring to accurately assess how all of its different stakeholders perceive a company’s ESG credentials.

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