How ESG Controversies Impact a Company [Part.2] - Seneca ESG (2024)

Ranging from monopolistic behaviors and accounting frauds to workplace harassment and environmental incidents, ESG controversies could have significant adverse effects on companies. ESG data vendors like MSCI, Refinitiv, Sustainalytics, ISS, all have scores or ratings to help analyze the impact of ESG controversies on corporates. For MSCI’s ESG Controversies Score methodology, please read the previous article: How ESG Controversies Impact a Company [Part.1].

Refinitiv: Lower controversy score leads to lower ESG combined score

Refinitiv designs ESG scores to measure a company’s ESG performance through ten categories under the Environmental, Social, and Governance pillars based on publicly reported information. As a supplementary, ESG controversies score is obtained according to global media sources, and is used as a discount rate on ESG scores to get a company’s final ESG Combined (ESGC) score.

(Source: Refinitiv)

ESG controversies score consists of 23 ESG controversy topics, including anti-competition, business ethics, intellectual property, tax fraud privacy, environmental issues, diversity & opportunity, etc. The default value of all controversy measures is 0, meaning companies with no controversies will get a score of 100%.

(Source: Refinitiv)

To harmonize the market cap bias, Refinitiv introduces severity weight, as it considers large-cap companies attract more media attention than small-cap companies. Based on a company’s market cap class, the corresponding severity weight will be multiplied by the count of controversies. For example, one controversy on employee’s health & safety occurred in a large company this year, so the adjusted value after applying severity weight is 1*0.33=33%. Then, the adjusted corporate value of 33% would be used in a percentile ranking of all firms in the company’s industry.

Percentile ranking, as the biggest feature of Refinitiv’s ESG scoring methodology, is a further step adopted to calculate ESG controversies score. To determine the ranking, three questions should be identified: in the company’s industry,

1) How many companies are worse than the firm?

2) How many companies have the same value with it, including itself?

3) How many companies have a value at all?

After applying severity weight to address market cap bias, companies within a certain industry all get their adjusted values, by which those companies will be sorted from lowest to highest, lower being better. In the last step, Refinitiv uses its percentile rank formula to derive the firms’ ESG controversies scores.

(Source: Refinitiv)

In Refinitiv’s methodology, ESG controversies score will be compared to the ESG score to get the ESGC score. If the controversies score is higher or equal to the ESG score, the ESGC score is the same as the ESG score. If the controversies score is lower than the ESG score, the ESGC score is the average of the ESG & ESG controversies scores.

ESG controversies have delayed effect, referring to a longer impact

High-profile ESG controversies tend to have a longer impact on companies. For example, German car giant Volkswagen [VOW:GR] was exposed to emissions scandal in 2015. However, the company still has a 0 MSCI controversy score despite having made organizational changes to fix the issues. According to Aviva Investors, there is always a delayed reward for taking action. In fact, MSCI scores require a company to post zero controversies for at least two years before resetting its score.

Refinitiv adopts a similar approach by dividing controversies into two types, respectively called recent controversies and normal controversies. For example, a company has its last completed fiscal year as December 31, 2019. If there was a controversy that occurred on May 1, 2020, and another on March 1, 2021. Both controversies are included in the scoring for fiscal year (FY) 2019, under the name of recent controversies. Once FY2020 is completed, the controversy on May 1, 2020, is moved to normal, while the other remains under recent. When FY2021 ends, the controversy on March 1, 2021, will be moved to the normal data point in FY2021. No controversy is double counted. Although Refinitiv does not disclose the scoring discrepancies of the two different types of controversies, such a method implies longer record retention of corporate controversies. From the approach, once a controversy occurs, it will drag down a company’s ESG combined score over two years.

The materiality of a controversy is strongly correlated to a firm’s business model

Though past controversies are not always a good guide to the future, companies need to fully understand and examine their business models’ sustainability and corporate practices. While some controversies happen occasionally, some actually reflect the defect of a business model and present themselves as obstacles to a company’s future growth. For example, a failure linked to the core product of a company is noteworthy, such as an oil spill for an oil company, an engine failure for a car company, and a medical accident for a pharmaceutical company.

In turn, this could also explain the reason why many tech companies’ share prices hardly dip or quickly bounce back after they made headlines for negative news. Most of the time, controversies occurred in other parts not pertaining to tech companies’ business models nor deeply embedded within those companies’ culture, so it seems that the tech companies are controversy proof. Despite this, companies’ remedial actions to mitigate the reoccurrence risks of incidents are necessary, while investors as well as the public are tracking the corrective actions before the controversy scores begin to reflect the improvement.

Reference

https://www.avivainvestors.com/en-us/views/aiq-investment-thinking/2021/04/controversy-scores/

https://link.springer.com/article/10.1057/s41260-020-00178-x

https://www.msci.com/documents/1296102/1636401/ESG_Controversies_Factsheet.pdf/4dfb3240-b5ed-0770-62c8-159c2ff785a0

https://www.msci.com/documents/1296102/14524248/MSCI+ESG+Research+Controversies+Executive+Summary+Methodology+-++July+2020.pdf

https://www.refinitiv.com/content/dam/marketing/en_us/documents/methodology/refinitiv-esg-scores-methodology.pdf

https://www.sec.gov/comments/s7-23-19/s72319-6660329-203852.pdf

https://www.sustainalytics.com/investor-solutions/esg-research/controversies-research

https://www.schroders.com/ru/sysglobalassets/digital/insights/2018/sustainability/q2-2017-schroders-sustainable-investment-report—public-version.pdf