The ability of ESG ratings to gauge the financial risk associated with a company’s greenhouse gas emissions is set to decline over the coming years as new policies emerge to align financial performance with emissions performance.
ESG ratings have been criticized in the past for failing to place enough weight on emissions. Rating agencies have reiterated that ESG ratings were never meant to be climate-focused metrics and instead encompass a broad array of environmental, social, and governance criteria.
A longstanding issue with ESG ratings
The disconnect between ESG ratings and emissions performance has been well studied. Research by the Organization for Economic and Cooperation and Development published last year found that emissions had little correlation with overall E scores, and E scores had little correlation with overall ESG scores. E scores contain a large number of metrics such as targets, the quality of reporting, and internal governance of environmental issues. As a result, emissions tend to get lost in the noise.
The mismatch between ESG ratings and emissions performance is going to become increasingly problematic for investors and corporations using ratings as an indicator of future company performance. Major new policies are being brought in to ensure that emissions performance impacts financial performance. The EU is extending its emission trading system (ETS) to cover additional sectors like road transport, shipping, and buildings. Free emissions allowances for heavy polluters like steel and cement polluters are to be gradually phased out. To stop ‘carbon leakage’, where industry moves abroad, the EU is phasing in a carbon border tax, its carbon border adjustment mechanism (CBAM).
The future outlook
While ETS and CBAM will hit heavy industry hardest, their impact will cascade down to virtually every sector of the economy. For companies trading with the EU or with EU subsidiaries, carbon reporting and emission reduction strategies are going to rise in importance.
The policy may well encourage trade partners to adopt some form of minimum carbon pricing. The UK is also considering its own version of CBAM. In the US, the Inflation Reduction Act (IRA) has already been followed by announcements of big investments in US electric vehicle and battery plants. The EU is concerned the IRA may be too successful and draw green investment away from the EU. In response, it is mulling plans for its own green investment subsidies and adjustments to its state aid rules.
As a result of these initiatives, emissions performance will begin to have a more pronounced effect on companies’ broader success or failure. Investors and corporates that use ESG ratings as a guide for identifying financially future-proofed companies are setting themselves up for disappointment.
