Today, if one wants to see how a college is placed in the pecking order,
one can get confused. Several ranking systems exist and their results are not
consistent, especially if one excludes the top institutes. Now Environmental,
Social and Governance (ESG) investing is the ‘next big thing’, with everyone
talking of it. Are you ESG compliant? This question will be asked of every
company and is hence very important. The government is talking of issuing
sovereign green bonds and the recipient of funds must be green-compliant.
Foreign investors are keen to invest in ESG-complaint firms. The Securities and
Exchange Board of India (Sebi) has come out with a paper on how credit-rating
agencies (CRAs) should go about this exercise. But wait. Some CRAs already have
ESG grades for around 500-1,000 companies. Was that just a rudimentary exercise
or has it been trivialized?
Such ratings have been assigned ostensibly based on the annual reports
of companies. Sceptics suspect these self write-ups could loosely be called
“bluff sheets", or, to be generous, “selectively crafted". Let’s see
how. All companies claim that they are doing a lot for the environment. While
businesses say they have changed bulbs and use auto switch-on/off power
devices, how many have dispensed with, say, bottled water? Private firms in
particular make employees work well beyond office hours, which consumes a lot
of power with large servers running overtime. There is something amiss here.
‘Social responsibility’ is also fuzzy. Every directors’ report talks of
how employees are the most treasured resource. But look back. During the
pandemic, private companies with big reserves sacked employees or made them
take pay cuts. Was this employee friendly? Hence, while we see touching images
of donations made to village schools, the harsh reality is that labour is
retrenched every now and then on grounds of enhancing shareholder value. It is
another thing that in these years, the top management laps up the cream in
terms of increments. Therefore, self proclamations are often an eyewash.
Governance write-ups can be questioned. Typically, firms talk of their
board composition, number of independent and women directors and the count of
meetings attended. Does this mean these boards are good and the best practices
of governance are followed? It is well known that in some owner-driven
businesses, even reputed directors are mere dummies. As for professionally-run
firms, how often have we heard of boards sacking incompetent and abusive chief
executives? It’s very rare. Typically, members spend not more than 24 hours a year,
earn ₹12 lakh upwards and are not really
interested. One can recollect an infamous case of sexual harassment in the
hospitality industry where the impotent board did not act and the lady had to
leave. Even through the recent crisis of the shadow-lending sector, directors
were not blanked out from other boards. The recent episode of a stock
exchange’s governance further weakens confidence.
Therefore, assigning ESG scores based on annual reports is fraught with
risk, especially if these are to be used for critical investment decisions. So,
can CRAs do this job? Only a measured answer is possible because the past does
not inspire confidence. First, CRAs have faced problems with getting data from
companies when they rate debt. The number of ‘Issuer not cooperating’ cases for
surveillance has increased manifold. Once such firms procure a rating, their
continued cooperation is not easy to obtain. The recent announcement of
entrusting CRAs to check the use of initial public offering (IPO) proceeds has
thus drawn mixed reactions.
Second, there is inherent conflict of interest. CRAs have subsidiaries
which would do such ratings. Given that rating shopping is the order of the
day, if a large company that pays a CRA, say, ₹5 crore in fees for a debt rating also asks for an
ESG rating, risks of a compromise assessment cannot be ruled out.
Third, CRAs have little competence in evaluating environmental and
social impacts. Horses that are raced at Mumbai’s Mahalaxmi race-course differ
from those that carry the elderly at hill stations, and the same applies here.
Therefore, a careful evaluation of all CRAs is necessary, and a blanket
permission for the job would be inadvisable.
Fourth, some CRAs are talking of using artificial intelligence and
machine learning for rating operations, which can be disastrous because
algorithms will use annual-report data that can’t always be taken at face
value. This should definitely not be permitted. Humans must decide ratings, not
machines.
So, what is the way out? First, Sebi should mandate that this job be
done by research institutions that specialize in ESG assessments. Second, if
CRAs have to be involved, it should be selective. Those that have stood the
test of time could be allowed, while others should be evaluated more seriously.
Third, even within CRAs, it should insist that those who work on these ratings
should be specially qualified for the task. An external rating panel with
experts in these fields should be compulsory until the system stabilizes.
As we embark on an important journey of ESG ratings that also involves
India’s government now, we need to ensure that no loose ends are left that can
return to haunt us. We must keep in mind past episodes of failure in the rating
industry for a strong edifice to be built. A slow beginning is better than
rushing in and then finding it difficult to go back. The crypto case is a
cautionary example; it seems hard to control crypto proliferation and there are
only compromises being made.
These are the author’s personal views
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