Commentary: Pendragon Stuart of sustainability consultancy Sancroft explores the importance of environmental, social and governance ratings, the risk of greenwashing, and what to do about it

Boohoo was riding high. The UK online fast fashion retailer had huge sales under lockdown and was highly rated by analysts, including in many ESG ratings. Then, in the space of a week, half its value was wiped away following accusations of modern slavery in its factories in Leicester. The puzzle is why clear early warning signs were ignored by investors and what this means for the world of ESG investment ratings and the impact on companies in all industries.

ESG investments have become big business: 2018-20 saw over $100bn flow into specialist ESG funds globally, according to Barclays. Meanwhile, ESG controversies have wiped $500bn off the value of US companies since 2014 (Bank of America). Growing regulation around ESG issues will drive even more attention. For instance, UK government proposals out for consultation last month would fine large companies if their products contribute to deforestation, or if they lack the due diligence and governance to prove this is not the case.

So ESG matters to investors and regulators. But is it measured and managed properly? This is where the Boohoo scandal has sent shockwaves through the system. Strong ESG ratings seemed to ignore long-running prominent accusations about poor labour practices, including a Channel 4 documentary in 2017 and a Financial Times investigation in 2018. How could these purpose-built ESG tools be so misleading?

Failures of the few could hurt the opportunities of the many by undermining the value of well-run ethical and responsible companies

This has supported cynical claims that ESG is just a way for investors to attract capital from wider, less price-sensitive audiences without making any meaningful change. Now we could be seeing an “emperor’s new clothes” moment, where ESG ratings are dismissed as greenwashing. Failures of the few could hurt the opportunities of the many by undermining the value of well-run ethical and responsible companies. So, how did this come about, and what does it mean for investors and corporations?

Ratings data is complex and because not everyone can supply the same data, it is often based on what is available. So, Boohoo scored in the top 29% of peers in the industry on ESG overall, according to the aggregator CSR Hub. But according to the Fashion Transparency Index it seems it managed to do so through very limited disclosure – disclosing nothing at all around traceability of materials and labour, which is exactly where the problems were.

This is not the only problem facing investors as they try to steer through ESG: there are also a wide variety of different ratings, with vastly different scores for the same companies. Tesla, for instance, is rated the best ESG-performing carmaker in the world by MSCI, but the worst by FTSE. Meanwhile, ESG covers a huge range of issues – should labour practices be worth more or less than contribution to climate change? What about plastic waste? Or toxic chemicals?

The solution lies in focusing on what matters to the business at hand. What will drive performance for the business, what represents the greatest risk? This is a fundamental shift for both investors and companies from a compliance-led approach to one that focuses on material impact and risk-management. That means ESG must become a strategic issue, not a box-ticking one, otherwise confidence will evaporate, and everyone will come out worse.

Blackrock emphasised this in its updated ESG policy, which calls for disclosure in line with the most important issues to a business, as defined by the Sustainability Accounting Standards Board (SASB). Many, including Fidelity and Legal & General, are looking beyond risk, calling for identification of new opportunities created by ESG questions.

When investors are overwhelmed with information, and struggle to see where to focus, companies have the responsibility and opportunity to direct them. For bigger companies, this can be through having direct conversations with investors, but for all companies this means knowing what the most important issues for your business are – both opportunities and risks – and making sure this information is readily available in simple formats.

In the post-Covid landscape, we must find better ways to look after workers and create more environmentally benign ways to reduce waste

So, companies must move away from promoting big stories on the small things. Flashy announcements about new paper-free policies that only affect 0.01% of spend just adds to the noise and risk of greenwashing.

Instead, companies should focus more on standard approaches that investors care about, like the Task Force on Climate-related Financial Disclosures (TCFD). This is a reporting standard that gets companies to map the risks and opportunities related to climate change. Major investors are now loudly calling for this from all companies, and in its Green Finance Strategy the UK government said it expected that all listed companies would disclose in line with TCFD recommendations by 2022.

As of July, $80bn has already been raised this year to pay for environmental goals through green bonds, showing the value of ESG done well. Such investment will become more important in the post-Covid landscape, where we must find better ways to look after our workers and communities and create more environmentally benign ways to reduce waste and improve yields.

There is a real threat that greenwashing could dilute belief in ESG, making better outcomes harder to achieve. But the antidote is to focus on the issues that matter, like labour in fashion and deforestation in agriculture, and not just rely on complex ratings as a crutch. Corporates are the key partners here – helping lead investors on where to focus, how to interpret data and new ways to create value together.

Pendragon Stuart is a consultant at international sustainability consultancy Sancroft.

ESG  Ethical funds  Tesla  TCFD  SASB  Fashion Transparency Index  Green Finance Strategy