Beware the blind rush for ESG ratings


Nowadays, if one wants to see how a university is placed in the hierarchical order, one can get confused. There are several ranking systems and their results are not consistent, especially if one excludes the best institutes. Now, environmental, social and governance (ESG) investing is the “next big thing,” and everyone is talking about it. Is it ESG compliant? This question will be asked of every company and is therefore very important. The government is talking about issuing sovereign green bonds and the recipient of the funds must meet the green requirements. Foreign investors are willing to invest in ESG-compliant firms. The Securities and Exchange Board of India (Sebi) has published a document on how credit rating agencies (CRAs) should go about this exercise. But wait. Some CRAs already have ESG degrees for around 500-1000 companies. Was it just a rudimentary exercise or has it been trivialized?

Such ratings have ostensibly been assigned based on the companies’ annual reports. Skeptics suspect that these self-written could be loosely called “bluff sheets” or, to be generous, “selectively crafted.” Let’s see how. All the companies claim that they are doing a lot for the environment. While companies say they have changed light bulbs and use automatic on/off devices, how many have dispensed with, say, bottled water? Private companies, in particular, have employees work well past office hours, which consumes a lot of energy with large servers running overtime. There is something wrong here.

‘Social responsibility’ is also confusing. Every directors’ report talks about how employees are the most precious resource. But look back. During the pandemic, private companies with large reserves have laid off employees or made them take pay cuts. Was this employee friendly? So while we see poignant images of donations being made to village schools, the harsh reality is that the workforce is reduced from time to time for reasons of enhancing shareholder value. Another thing is that in these years, top management licks the cream in terms of increases. Therefore, self-proclamations are often an eye wash.

Governance articles can be challenged. Companies typically talk about the composition of their board, the number of female and independent directors, and the number of meetings they attended. Does this mean that these boards are good and that best governance practices are followed? It is well known that in some owner-driven companies, even renowned directors are mere fools. As for companies run by professionals, how often have we heard of boards firing incompetent and abusive CEOs? is very rare. Members usually spend no more than 24 hours a year, earn $12 lakh upwards and they are not really interested. One can recall an infamous case of sexual harassment in the hotel industry where the powerless board failed to act and the lady had to leave. Even through the recent crisis in the shadow lending sector, directors were not excluded from other boards. The recent episode of stock market governance further weakens confidence.

Therefore, assigning ESG scores based on annual reports is fraught with risk, especially if these are to be used for critical investment decisions. So can CRAs do this job? Only a measured response is possible because the past does not inspire confidence. First, CRAs have faced problems obtaining data from companies when rating debt. The number of ‘Uncooperative Issuer’ cases for surveillance has multiplied. Once such companies get a rating, it is not easy to get their continued cooperation. The recent announcement to task credit rating agencies with verifying the use of IPO proceeds has drawn mixed reactions.

Second, there is an inherent conflict of interest. CRAs have subsidiaries that would make such ratings. Since rating buying is the order of the day, if a large company that pays for a CRA, for example, $5 crore in fees for a debt rating also calls for an ESG rating, the risks of a compromise assessment cannot be ruled out.

Third, CRAs have little competence to assess environmental and social impacts. The horses that race at Mumbai’s Mahalaxmi Racecourse differ from those that carry the elderly at hill stations, and the same applies here. Therefore, a careful evaluation of all CRAs is necessary, and a general permit to work would not be recommended.

Fourth, some CRAs are talking about using artificial intelligence and machine learning for rating operations, which can be disastrous because the algorithms will use annual report data that can’t always be taken at face value. This definitely should not be allowed. Ratings should be decided by humans, not machines.

So what is the way out? First, Sebi should mandate that this work be done by research institutions that specialize in ESG assessments. Second, if it is necessary to involve credit rating agencies, it must be selective. Those that have stood the test of time might be allowed, while others should be more seriously evaluated. Third, even within CRAs, it must be stressed that those working in these qualifications must be uniquely qualified for the task. An external rating panel with experts in these fields should be mandatory until the system stabilizes.

As we embark on a major ESG ratings journey that now also involves the Government of India, we need to ensure there are no loose ends left to come back to haunt us. We must take into account previous episodes of failure in the ratings industry to build a solid edifice. A slow start is better than rushing in and then having a hard time coming back. The crypto case is an example of a warning; it seems difficult to control the proliferation of crypto and only concessions are being made.

These are the personal opinions of the author.

Madan Sabnavis is Chief Economist at Bank of Baroda and author of ‘Hits and Misses: The Indian Banking Story’

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