By Bernhard Bartels, Head of ESG Analysis

ESG ratings measure the financial risks companies are exposed to arising from sustainability but they fail to quantify the impact that companies themselves have on the world. The way ESG ratings are currently designed is dominated by governance issues. This is because governance or compliance pose an immediate risk to the companies concerned in the form of reputational and revenue risks; risks that are relevant for investors.

There is a big difference between risk and impact, which explains why electric vehicle manufacturer Tesla is excluded from the S&P 500 ESG Index while energy company Exxon Mobil is included. Exemplary governance structures in the oil and gas industry often compensate for the negative impact that the business models have on the world – as can be seen in the different MSCI ESG ratings of Shell (AA, "Leader") and Volkswagen (B, "Laggard").

When looking at ESG risks, ratings give priority to the financial impacts on a company. Impact considerations, on the other hand, are about the environmental and social impacts a company and its products create. But many investors and users of ESG ratings are unaware that the impact dimension in conventional ESG ratings is missing. This creates misunderstandings. Even managers of Article 9 funds – so-called impact funds – select their holdings partly with the help of ESG ratings, although they predominantly assess ESG risk.

Why do ESG ratings focus so much on ESG risks and neglect the issue of impact? Why are the environmental and social impacts of business models not considered in the ratings when they should be at the centre of sustainability assessments?

One answer is companies have to-date only reported their impact to a limited extent. Information about greenhouse gas emissions, water consumption, employee development, equal pay and good corporate governance is now part of the standard repertoire. But reliable impact assessments also require detailed data on corporate value chains. This includes, for example, information on the extent of child labour or corruption from imported inputs.

Upstream and downstream inputs

A complete impact assessment should reflect not only the negative and positive impacts of a company’s activities on the environment and society but also the impacts of purchased (upstream) inputs. Steel imported from China may have an even higher impact on the environmental balance sheet of the purchasing company than its own production at home.

In addition, there are impacts generated by the use of the manufactured goods and services (downstream). Over its lifetime, a car causes significantly more impact on the environment and society than its production. This must be reflected in the impact assessment of the manufacturing company. However, the data required for a comprehensive impact assessment is not readily available and most companies do not publish it.

We are only at the beginning but there is a clear trend in sustainability reporting towards more impact-related indicators. For example, most of the large German companies in the DAX-40 index have announced that they will increasingly report on their indirect greenhouse gas emissions in the coming year – if they have not already done so. Regulatory requirements in Europe are also pushing companies towards more impact reporting. The first drafts of the Corporate Sustainability Reporting Directive already provide for extensive reporting obligations on supply-chain impacts.

The greater focus on impact in current regulatory workstreams and in the information reported by companies will help to increase the value of ESG assessments and will make greenwashing more difficult. But it will take time for companies to adopt European reporting standards and for financial market participants to fully implement impact into their investment decisions. If impact is to become a central aspect of corporate action, producers and users of ESG ratings must follow the same path.

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