Beware of the crowd blinded to ESG ratings

Such ratings are explicitly assigned based on the companies’ annual reports. Skeptics suspect that these self-writings may be loosely called “bluff sheets”, or, to be liberal, “selectively drawn”. Let’s see how All companies claim that they are doing a lot for the environment. While businesses say they have changed bulbs and use auto-switch-on/off power devices, how many have done away with bottled water? Private firms especially employ employees well beyond office hours, which consume a lot of power with large servers running overtime. There’s something wrong here.

‘Social responsibility’ is also fuzzy. Each director’s report talks about how employees are the most valuable resource. But look back. During the pandemic, private companies with large reserves have fired employees or cut their salaries. Was this employee friendly? So, when we see poignant images of donations made to village schools, the harsh reality is that labor is periodically retrenched on the basis of increasing shareholder value. It is another matter that over the years, the top management outperforms the cream in terms of salary increase. Therefore, self-declarations are often an eyewitness.

The writings of the government can be questioned. Typically, firms talk about the composition of their boards, the number of independent and female directors, and the number of meeting participants. Does it mean that these boards are good and best practices of governance are followed? It is well known that in some owner-run businesses, even reputed directors are simply dummies. As far as professionally operated firms are concerned, how many times have we heard of boards sacking incompetent and abusive CEOs? This is very rare. Typically, members spend no more than 24 hours a year, earning 12 lakhs up and not really interested. One can recall an infamous case of sexual harassment in the hospitality industry where the impostor board did not act and the woman had to be released. Even during the recent crisis in the shadow-credit sector, directors were not vacated from other boards. The recent episode of stock exchange governance has dented confidence further.

Therefore, assigning ESG scores based on annual reports is fraught with risk, especially if they are used for important investment decisions. So, can CRAs do this? Only a measured answer is possible because the past does not inspire confidence. First, CRAs face problems in obtaining data from companies when they appraise loans. The number of ‘issuers not cooperating’ cases for surveillance has increased manifold. Once such firms get ratings, it is not easy to get their continued support. The recent announcement to hand over the CRA to investigate the use of the initial public offering (IPO) proceeds has thus drawn mixed reactions.

Second, there is a conflict of vested interests. CRA has subsidiaries that carry out such ratings. Given that rating purchases are the order of the day, if a large company that pays CRA, say, 5 crore in charges for debt rating also adds to ESG rating, the risk of a compromised valuation cannot be ruled out.

Third, the CRA has little capacity in evaluating environmental and social impacts. The horses running at Mumbai’s Mahalaxmi Race-course are different from the horses that take the elderly to hill stations, and the same applies here. Therefore, a careful evaluation of all CRAs is necessary, and a broad permit for the job would be inappropriate.

Fourth, some are talking about using artificial intelligence and machine learning for CRA rating operations, which can be disastrous because the algorithm will use annual-reported data that may not always be taken at face value. It certainly shouldn’t be allowed. Humans should decide the ratings, not machines.

So, what is the way? First, SEBI should mandate that this work be done by research institutions specializing in ESG assessment. Second, if CRA is to be included, it must be selective. Those that have withstood the test of time may be allowed, while others should be evaluated more seriously. Third, even within the CRA, it should be emphasized that those who operate on these ratings must be particularly qualified for the job. An external rating panel with experts in these areas should be mandatory till the system is stable.

As we embark on an important journey of ESG ratings, which now includes the Government of India, we need to ensure that there are no loose ends left that could haunt us. We must take into account previous episodes of failure in the ratings industry to build a strong building. It is better to start slow than to hurry up and then go back hard. The crypto case is a cautionary example; Controlling the crypto spread seems hard and only agreements are being made.

These are the personal views of the author

Madan Sabnavis is Chief Economist, Bank of Baroda, and author of ‘Hits and Mrs: The Indian Banking Story’.