Where ESG Ratings Fail: The Case for New Metrics

0
3

By Mark Kramer, Nina Jais, Erin Sullivan, Carina Wendel, Kerry Rodriguez, Carlo Papa, Carlo Napoli, and Filippo Forti


Corporate leaders, investors, and analysts today must deal with two separate and entirely disconnected reporting systems: one for financial results and the other for environmental and social impact, or ESG, performance. Companies can be screened in or out using various criteria, but there is no way to integrate the data into earnings projections or valuation analysis. The result is two separate narratives, one telling how profitable a company is, the other highlighting whether it is good for people and the planet. There is no clear way to discern which company is most profitably doing the most good.

Investors, therefore, cannot accurately assess whether a company’s sustainability or shared-value strategies are creating shareholder value, and thus miss an important dimension of corporate performance that may affect future earnings. Eventually, an increase in shareholder value will manifest in long-term financial performance. But investors end up mispricing securities in the near term and management teams lose out on timely rewards in their market capitalization when those teams create shared value. This produces a strong disincentive for both investors and corporate leaders to prioritize social or environmental impact in their day-to-day decision-making. 

Moreover, even if company executives want to give weight to societal priorities, the absence of any internal decision-making framework that integrates social and environmental impact with its economic consequences prevents them from finding optimal solutions. 

No definitive evidence linked social and financial metrics until very recently. In the past few years, however, a growing body of research has demonstrated that there is a strong correlation between ESG performance on factors material to a given industry and the financial performance of companies over time, including stock performance. This suggests the possibility of a single hybrid measurement system that combines social and environmental impact with standard measures of financial performance to make the connection explicit. 

Italian electricity company Enel, for example, has a multiyear strategy to shift from fossil fuels to renewable power generation. This change, together with network digitalization, will offer higher profitability and lower volatility. Decarbonization, therefore, links directly to EBITDA. Once the correlation is validated, a hybrid metric based on the ratio of EBITDA to carbon intensity could be compared against industry peers’ to determine which utility is most profitably shifting to renewable energy. 

That metric could also help predict changes in earnings based on planned investments in renewables or in decommissioning coal- and gas-fired power plants. Similar hybrid metrics could link profitability to health outcomes for health insurance companies or to nutritional value for food and beverage companies. They could also link employee productivity to wages and benefits in service and retail industries, or the cost of goods sold to labor conditions in the supply chain for clothing companies. 

LEAVE A REPLY

Please enter your comment!
Please enter your name here