The Duality of Variance Among ESG Assessments.

AuthorKim, Sung Eun (Summer)

TABLE OF CONTENTS ABSTRACT 409 TABLE OF CONTENTS 411 I. INTRODUCTION 412 II. THE RISE AND FALL OF ESG GATEKEEPING 416 A. The Rise of ESG 417 B. The Rise of ESG Gatekeeping 425 C. Variance Among ESG Assessments: The Fall of ESG 428 Gatekeepers? III. THE DUALITY OF VARIANCE AND CONVERGENCE AMONG ESG ASSESSMENTS 433 A. Harmful Convergence (Optimal Variance) 434 1. Weak Theorization and Commensurability 434 2. Value Plurality 435 3. Inflation and Groupthink 438 4. Competition 440 B. Harmful Variance (Optimal Convergence) 441 1. Inconsistencies Over Time 441 2. Inconsistencies Across Firms 443 3. Manufactured Complexity 444 IV. FOSTERING OPTIMAL VARIANCE AMONG ESG ASSESSMENTS 445 A. Disclosures 445 B. Standardizing Inputs 446 C. Regulating Ratings Shopping 447 D. Gatekeeper Governance and Pricing Policies 447 V. CONCLUSION 448 I. INTRODUCTION

Traditionally, a firm's success or failure has been measured by its ability to generate financial returns for its shareholders. This financial view of corporate performance--also referred to as the shareholder primacy norm (1)--has been praised for its efficiency, but also criticized for its disregard of shareholders' non-financial interests and the interests of non-shareholder stakeholders, such as consumers, (2) workers, (3) and the environment and society. (4)

The recent growing interest in firms' environmental, social, and governance ("ESG") activities seeks to supplement the shareholder primacy norm with non-financial measures of corporate value and performance. While non-financial assessments of economic activity have been documented as early as the nineteenth century, (5) it is only within the past few years that EsG has begun to receive widespread acceptance as a measure of firm value, (6) particularly among investors. (7)

The UN Principles for Responsible Investment, an international organization that promotes the incorporation of EsG factors into investment decision-making, reports that more than 3,000 investors representing over $100 trillion in assets have committed to integrate EsG information into their investment decisions in 2020. (8)

While investor interest in EsG is an important prerequisite to the success of EsG reforms, it has also been a source of divide, especially in understanding the relationship between EsG and shareholder primacy. Some investors view ESG as a tool of shareholder primacy--a pathway to generate even greater financial returns and reduce risks for a firm's shareholders. (9) others view EsG as embodying a value of its own, acknowledging that it can even sometimes be in tension with shareholder primacy's norms. This Article refers to the former view as the financial view of ESG, and the latter view as the values-based view of ESG. The dichotomy between the financial and values-based views of EsG has been described as ESG's "existential defect," (10) and fundamentally impacts one's understanding of whether and why ESG matters.

As these debates and overall interest in ESG have intensified, ESG data and ratings providers are serving an increasingly important role in the ESG discourse. (11) According to KPMG, there were 160 ESG ratings and data products providers worldwide in 2020. (12) And according to ERM, a sustainability consultancy, there were more than 600 ESG ratings and rankings products available globally as of 2018. (13) Moreover, UBS estimates that revenues from ESG data and service provision will double its 2020 levels by 2025. (14)

Even as the number and types of ESG providers and products have grown, the lack of ESG data has been cited as an impediment to a broader embrace of ESG considerations. A 2017 BNP Paribas survey of institutional investors, for example, revealed that more than half (55%) of respondents regarded the lack of robust ESG data as the most significant barrier to greater adoption of ESG strategies. (15)

This perception of inadequacy of ESG data stems in part from the widely reported variance among ESG assessments. Variance among ESG assessments has been a key focus of the academic research on ESG data providers. The emerging consensus is that variance among ESG assessments is a reason to doubt their accuracy and validity. (16) Credibility is the lifeblood of gatekeeping, (17) and these studies have led to a legitimacy crisis for ESG gatekeepers and, furthermore, the ESG movement. (18)

This Article's main contribution to the ESG literature is its emphasis that convergence among assessments is not always an indicator of their accuracy or reliability. As a recent example, the credit ratings of structured finance products among credit ratings agencies during the 2007-2008 period were highly convergent yet were later revealed to have been inflated. (19) The inflated ratings were blamed for catalyzing one of the most devastating financial recessions in recent history. (20) Inflated ratings were also at the heart of the dotcom bubble, (21) the East Asian Financial Crisis, (22) and the accounting scandals of 2001 and 2002 that led to the collapse of Enron and other landmark corporations. (23)

Recognizing this duality of convergence and variance among assessments--i.e., that neither are categorically harmful or desirable--this Article provides a framework that can be used to distinguish between healthy and harmful forms of variance among ESG assessments. Variance among assessments is harmful when it is the product of poor-quality data, inconsistencies in methodology (within the same assessor), ex post rewriting (to fit a desired narrative), or prejudice and bias. On the other hand, convergence among assessments is harmful when it is the product of inflation, capture, groupthink, or monopolistic market conditions.

After analyzing these harmful and optimal forms of variance and convergence among ESG assessments, this Article surveys market and regulatory interventions that can be used to foster optimal forms of variance and to mitigate harmful forms of variance.

The rest of the Article proceeds as follows. Part II provides an overview of the growing ESG movement and the corresponding growth in ESG gatekeeping. Special attention is paid to how variance among ESG assessments has created a legitimacy crisis for ESG gatekeepers. Part III supplements the general trend in the literature raising the alarm on variance among ESG assessments with a contrasting account that views variance as potentially indicative of a healthy forum for diverse ideas and opinions. Both accounts are applicable to the ESG context, and Part III provides an analytical framework that can be used to distinguish between harmful and healthy forms of variance among ESG assessments. Part IV surveys market and regulatory interventions that can be used to mitigate harmful forms of variance and convergence among ESG assessments. Part V concludes.


    As more attention is given to ESG considerations of corporations, ESG data and ratings providers are serving an increasingly important function in the ESG discourse. This Part describes the growing prominence of ESG and ESG gatekeepers in the corporate landscape, and the legitimacy crisis of ESG gatekeeping that has been fueled by the widely documented variance among ESG assessments.

    1. The Rise of ESG

      Historically, corporations have been evaluated on their ability to generate financial returns for their investors. This financial view of corporate performance--also referred to as the shareholder primacy norm--has been praised for its efficiency but also criticized for its potential detriment to non-shareholder stakeholders, such as consumers, workers, the environment, and society. (24) The embrace of ESG considerations of firms seeks to supplement this traditional perspective of firm value with environmental, social, and governance considerations.

      While non-financial valuations of firms can be traced back to as early as the nineteenth century, the modern roots of the ESG movement were planted in the 1970s, when the United Nations Environment Programme ("UNEP") was established at the UN Conference on the Human Environment in Stockholm. (25) The UNEP is the global authority for the environment, focusing on climate, nature, and sustainable development. (26)

      In 2005, the UNEP published A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment (referred to as the Freshfields Report), which encouraged ESG integration into investment decisions. (27) Furthermore, in 2015, all UN Member States adopted the UN Sustainable Development Goals ("SDGs"), a collection of seventeen goals that create a "shared blueprint for peace and prosperity for people and the planet, now and into the future." (28) In the United States, the Forum for Sustainable and Responsible Investment was founded in 1984 with the mission of shifting investment practices toward sustainability. (29)

      The Environmental (E) pillar among ESG considerations examines a firm's efforts to conserve nature and includes a firm's impact on climate change, carbon emissions, air pollution, water pollution, biodiversity, deforestation, energy efficiency, waste management, and water scarcity. (30) The Social (S) pillar examines a firm's relationships with its stakeholders, and includes customer satisfaction, data policies, commitment to gender and diversity issues, employee engagement, community relations, human rights, and labor standards. (31) The Governance (G) pillar examines how a firm is run, and includes its board composition, audit committee structure, bribery, corruption, executive compensation, lobbying, political contributions, and whistleblower policies. (32)

      While these categorizations might suggest that each pillar is distinct, the three pillars are often intertwined. For example, the issue of greater diversity on corporate boards implicates both the Social (S) and Governance (G) pillars of ESG.

      A common critique of ESG is that it is too amorphous to be used as...

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