ESG Uncertainties Could Cause Clashes

Suddenly, a whole lot is riding on how well public companies perform on ESG metrics. Last week, we told you about the emergence of sustainability-linked loans, the latest generation of so-called green loans. Major multinationals such as BlackRock and Royal Dutch Shell are entering SLLs, in which interest rates and other terms are linked to the borrower’s performance on sustainability metrics.

Executives have skin in the ESG game, too. As recent disclosures note, Salesforce.com and XPO Logistics Inc., for instance, have tied their executive compensation to ESG performance. XPO says that 25% of its executives’ long-term cash incentive awards are now dependent on the company’s performance on an “ESG scorecard” that considers metrics including employee safety and diversity.

It sounds great in theory. In practice, however, the terms in many SLLs and other incentive programs depend on a company’s ESG ratings, as determined by one of several ESG ratings services. And who, exactly, is grading the ESG graders?

In a post last week on the CLS Blue Sky Blog, Colleen Honigsberg and Paul Brest of Stanford Law School noted “there is little correlation among the scores that different ESG ratings services assign to the same companies.” Although nobody thinks scoring systems should produce identical evaluations, wildly disparate results between systems don’t inspire much confidence that they’re giving useful – or accurate – information.

So, what makes an ESG scoring system trustworthy? Honigsberg and Brest identified three features of a credible ESG scoring system:

• Systems should involve “a limited set of metrics that capture key environmental and social impacts.”
• A standard-setting organization should define the metrics.
• Companies “must have auditable processes for collecting, reporting, and verifying the relevant metrics.”

Given how early we are in the life cycle of ESG measurement and reporting, it stands to reason that currently, many systems would struggle to clear all those bars.

The Biden administration’s ongoing effort to set the parameters for sustainability reporting could bring some needed clarity. (Bear in mind that even that project is drawing criticism from conservative policy analysts and Republican SEC Commissioner Hester Peirce.) In the meantime, however, the vagaries of ESG reporting and grading would seem to create a breeding ground for disputes, with so many loan payments and executive paychecks hinging on them.

Meanwhile, the Securities and Exchange Commission is sounding the alarm regarding potentially bogus claims related to ESG investment products. In a risk alert issued earlier this month, the agency explained some of the risks presented by the explosion of ESG products, such as confusion among consumers stemming from “the variability and imprecision of industry ESG definitions and terms.”

Indeed, there is plenty of room for confusion in the ESG space these days. And now that ESG scoring is embedded into so many contract terms, the sooner it can get cleared up the better.