Lexant - ESG rating "dilemma": balancing standardization and differentiation

The growing ask for sustainability assessment has favored the rise of several players measuring the corporate sustainability performance. This scenario has created an increasingly competitive market based on multiple assessment approaches which affect commensurability.

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Corporate sustainability has become crucial in investors' decision-making. The ESG (Environmental, Social, Governance) criteria identify an era where the stock market is no longer limited to considering financial statements but also evaluates environmental impact, social externalities, and the quality of corporate governance.

However, measuring ESG performance implies several challenges. This activity is characterized by significant heterogeneity in evaluation processes, underlying the various methodologies that often lead to discordant results, creating uncertainty for investors in comparing companies and understanding the real commitment of a company to sustainability.

The paradox relies on the attempt to standardize ESG evaluation metrics, aiming to simplify comparison among entities. Meanwhile, it requires a tailored measurement to meet companies' idiosyncrasies, especially for SMEs, that are tied to the context and their local stakeholders.

This issue becomes relevant when examining the ESG rating process. Indeed, many agencies do not disclose significant elements of their methodologies, making ex-post analysis challenging due to the increasing information asymmetry between companies and investors. Moreover, adopting different metrics meant to assess the same ESG factors fosters inconsistencies, highlighting the "dilemma" between the need to ensure reliability and transparency through standardization and a context-driven metric reflecting the stakeholders' instances and the environment where an organization operates.

On this ground, new pathways could be explored to improve ESG assessment. A solution could consist of a more dynamic and adaptive methodology, especially for SMEs, which could benefit from a more-tailored rating system that better captures their sustainability practices and local impact initiatives.

The dynamic approach guarantees the entities a consistent "space-time" commensurability to monitor improvements over time and identify a benchmark of the industrial sector.

However, the adaptive aspect provides a territorial differentiation of the evaluation process, detecting and monitoring the social, environmental, and economic factors of a given context, as well as the categories of stakeholders on which a company can have a significant impact.

Hence, the impact assessment would be framed as a geo-differentiated and stakeholder-based approach, considering the contingency of a specific context.

In conclusion, the outstanding debate between standardized and tailored approaches denotes the need to carry on an in-depth analysis to understand how corporate governance can meet the material issues of a given context.

In doing so, the ESG raters should rely on recognized theoretical frameworks – such as the Stakeholder Theory and the Contingency Theory – to conceptualize an agreed definition of sustainability. This, on the one hand, could reduce the misalignment of rating issuance (i.e. heterogeneity) and, on the other hand, might shape the assessment procedures to the local and contingent topics (i.e. tailored approach).