Sense and Nonsense in ESG Scoring

Abstract

Concerns about the future of the natural environment, prevailing social conditions, and governance of private and public institutions inspire today’s ESG movement. None of these concerns are new. But they have gained much traction from the techno-communication revolution alongside a growing populist focus on “stakeholder” claims. This paper proposes a coherent heuristic for sorting out the elements of a social control platform that captures the key elements of the ESG movement from the perspective of modern business firms and investment funds that mostly operate under the classic conditions of market discipline. The diagnostic radiates from regulatory constraints anchored in legislation – and that bear most directly on the enterprise – outward to much less tractable areas of business conduct subject to claims and values that may or may not be generally accepted. The ESG ratings industry attempts to identify, calibrate and condense corporate and investor conduct across a wide spectrum of behavior against the benchmarks of normative ESG values. The industrial economics of the large and growing ESG ratings industry is discussed and compared to the credit rating industry with its long history and vastly simpler mandate – the probability of contractual debt service “on time and in full.” The paper concludes with an assessment of the future of ESG ratings and their bearing on capital investment and business practice.

Keywords: environmental degradation, social impact, sustainability, corporate governance, corporate ratings, target funds, investment fund performance

JEL Classification: B55, D18, D30, D62, D68, D74, F53, H89, I30, K29, K38, K42, K49, Z128