Institutional investors increasingly consider third-party environmental, social, and governance (ESG) ratings as part of their credit and risk assessment process for potential investments. Too often, these ESG ratings are misunderstood, oversimplified or misapplied as part of a check-the-box compliance exercise divorced from their real utility in assessing one or both of these key questions:
How is the issuer potentially exposed to ESG-related risks in ways that might not be apparent from traditional financial analysis (i.e., corporate value)?
Does the issuer or the particular investment meet the investor’s own goals with respect to sustainability and impact on the environment, employees, local communities, suppliers and other stakeholders (i.e., corporate values)?
In most cases, ESG ratings emphasize only the risks that are material to the issuer (just the first question above), not sustainability writ large. ESG ratings evaluate the performanc