Environmental, Social & Governance Briefs

Beware the 80/20 Governance Trap: Where External ESG Ratings Fall Short – and Why

February 07, 2019

The recent downfall of California utility PG&E should cause pause in companies across many industry sectors. PG&E filed for bankruptcy on January 29, 2019, facing wildfire liability exposure to be as high as $30 billion – roughly triple the company’s market value of $9.12 billion.  The Wall Street Journal called this “the first major corporate casualty of climate change.”

Judging its external environmental, social or governance (ESG) ratings, PG&E was doing just fine. Sustainalytics rated the company as an “outperformer” (in 88^th percentile on Environment and 82^nd percentile on Governance). Corporate Responsibility Magazine’s 100 Best Corporate Citizens rated PG&E #1 among utilities and #22 overall. Newsweek Green Rankings listed the company #1 among electric and gas utilities and #4 overall. And, Dow Jones Sustainability North America Index named PG&E for the eighth time.

So we have a situation of high external ratings and a company apparently in compliance. Yet a $30 billion environmental liability exposure happened anyway. Clearly there is a disconnect somewhere.

In a day when many leading companies tell me “we have our hands full with a variety of disclosures and ratings that are of great interest to our stakeholders,” the PG&E situation should cause you to ask if your company has this right.

 

The Current Situation

According to US SIF (The Forum for Social and Responsible Investment), sustainable, responsible and impact investing (SRI) assets now account for one in four dollars of the $46.6 trillion in total assets under professional management in the United States. Asset managers now consider ESG criteria across $11.6 trillion in assets, up 44 percent from $8.1 trillion in 2016.

To support investor needs, ESG rating agencies and assessment tools have grown rapidly over the past 30 years. In a recent report (ESG Rating and Ranking Initiatives – A Necessary Evil?) The Conference Board provides a comprehensive overview of this crowded playing field.

ESG ratings and rankings are especially well suited to assess those aspects of ESG that can be quantified – or, as one major investor said, “fit on an Excel sheet.” This works for many environmental and social impacts (e.g., greenhouse gas emissions, water discharges, safety record, etc.) and for a few aspects of corporate governance (e.g., gender diversity of the board).

 

Beware the 80/20 Governance Trap

Here’s the rub. The simple fact is that only a very small portion (let’s call it 20 percent) of what constitutes robust sustainability governance and strategy can be measured from outside the company. The other 80 percent – what I call “the soft stuff” – is comprised of the internal company practices and business processes to manage risk and opportunity.

That 80 percent does not easily “fit on an Excel sheet.” For example, while external ESG raters may measure the existence of a board committee, it is almost impossible for them to measure the effectiveness of C-suite and board deliberations about ESG risk.

Bottom line: a company may be in compliance today and may receive high marks from external ESG raters; but executives and board members should take all of that with a grain of salt.They should insist on measuring the other 80 percent of what constitutes robust governance.

 

The “Soft Stuff” Can be Measured

As I wrote in “Navigating the Sustainability Transformation” (a Director Notes published by The Conference Board in 2015), companies can measure the “soft” components of sustainability governance. They can measure the effectiveness of C-suite and board deliberations about ESG risk. The Director Notes describes a four-stage maturity model called the Corporate Sustainability Scorecard that tracks a company’s progress from initially Engaging (Stage 1) with sustainability to ultimately Transforming (Stage 4) their company to fully embrace ESG and become model 21^st century corporations.

In 2018, 60 major global companies (including eight utilities) participated in a comprehensive benchmarking exercise using the Corporate Sustainability Scorecard. (Most of the companies were members of one of The Conference Board’s executive sustainability councils.) In analyzing the results, the eight utilities rated themselves fairly low on over a dozen "key sustainability indicators" (KSIs) that aim squarely at the kind of ESG risk oversight issues highlighted in the PG&E situation. On those dozen KSIs, the peer utilities rated themselves on average at about Stage 1.7 on a stage 1-4 maturity scale. In other words, they acknowledged they have a long way to go if they deem those items material to their business.

 

What to Take Away

I do not know what went amiss at PG&E. [Note: the author does not have any relationship with PG&E and is only using public information about this situation as an example to illustrate the limitations of external ESG ratings.] However, the average company self-assessment ratings by eight utilities, provided confidentially, paint a dramatically different picture than what the external ESG raters said about PG&E.

Perhaps it is time your company rethinks the effort spent on external ratings and invested some of that effort improving internal ESG governance processes.