The concept of ESG (environmental, social, and governance) has gone from being a buzzword to becoming an integral part of banks and businesses agendas. Financial institutions, as key facilitators of a more sustainable future, have the responsibility to prioritize ESG investments. In this paper, we look at the divergence and validity of ESG ratings which affect investor choices.
From 2018 to 2020, the number of managed funds using sustainable investing strategies increased by almost 50 percent and has been rising steadily since1. The rising number of portfolio managers integrating ESG factors into their stock selection methods and the need for extensive research of companies’ ESG performance has led to the establishment of rating agencies. These rating institutions evaluate firms’ performance and provide ESG ratings based on ESG policies, systems, measures and non-financial information. Using hundreds of metrics across environmental, social and governance concerns, each agency applies their own methodology, weighting policy and algorithms, deriving information from media sources, government data banks, annual reports, non-governmental organizations as well as interviews, questionnaires, and independent analysis. These metrics are used by agencies to identify potential business risks related to ESG issues, to establish a relative performance of companies against their peers and as a benchmark to obtain a universal rating comparable across industries.
Numerous studies have shown that stocks with high ESG ratings perform relatively better with higher excess return. In the long term, firms with higher ESG ratings outperform their less sustainable counterparts. Furthermore, companies who attach higher importance to ESG issues have a lower cost of equity or debt by facing lower capital constraints. Finally, these companies also enjoy higher market valuations. As a result, ESG ratings have a significant impact on investment decisions, asset prices and corporate policies. It is essential that the ratings are valid, which is not always obvious.
Numerous studies have shown that rating systems differ significantly among ESG rating agencies, which leads to different ratings for the same company. Even the format of these ratings varies from numerical scores to percentages or letter grades. While some common dimensions exist, there is no uniform standard. The divergence of ESG ratings can become a major issue as more investors use these ESG ratings and non-financial data to make their investment decisions.
This lack of uniformity leads to several important consequences. Firstly, it affects the primary focus of ESG ratings by making it difficult to evaluate the ESG performance of companies, funds, and portfolios. Secondly, firms are less incentivized to improve their ESG performance because of the ESG rating divergence. Companies receive mixed signals from rating agencies about which actions are expected and will be valued by the market. This might lead to underinvestment in valuable activities aimed at improving sustainability. Lastly, markets are less likely to price firms’ ESG performance ex post. ESG performance may be fundamentally value-relevant or affect asset prices based on investor tastes; in either case, however, the divergence of the ratings disperses the effect of ESG performance on asset prices.
An additional issue arises with the weighting assigned to each metric. To score and add together the various indicators to calculate the overall ESG rating and ratings for E, S and G, a ‘trade-off’ between indicators becomes necessary. For example, a firm that scores well on the diversity indicator might perform badly on board independence. Although many rating methodologies are likely to assign the same weight to these two indicators to combine them, not all are created equal, and the desired outcome depends on what the investor is looking for. For example, a low board-independence forms a greater business risk in comparison to a low gender-diversity board. Adding up the indicators presents significant differences between the performance and the risk, which comes by aggregating empirically and conceptually distinct ESG constructs.
These examples show the importance of valid ESG ratings and metrics to sustainable finance. Investor preferences for ESG affect asset prices, and as ESG ratings are used to guide investment choices, their construction or lack of uniformity is a major concern.
The low convergence in the rating agencies' assessment of ESG factors is due to both definitional and methodological differences. These differences arise in the definitions of ESG factors, their composition, the weightings for the environmental, social and governance factors, as well as the level of importance - or the weight - the rating providers assign to each attribute (e.g. animal testing or compliance with environmental regulations) and the different views held by agencies about which factors are considered financially material.
In addition, the methodological differences stem from the different measurements of the individual ESG factors and the information sources used by the rating agencies to develop their ratings. Some rating agencies use only public information, while others focus exclusively on companies’ self-disclosure, and some rely on both. However, information that is publicly disclosed by companies can bias the ESG ratings.
Choosing reliable ESG rating providers is no easy task for investors, and the discrepancies between ESG ratings can be roadblocks to better performing ESG investment strategies. However, this should not hold back investors looking to adopt an ESG strategy.
While waiting for further regulatory guidance from ESMA, financial institutions can prepare themselves for dealing with potential challenges resulting from the ESG ratings discrepancies, by considering the following actions:
Once the most important risk factors have been identified within the three ESG pillars, a thorough analysis of the investor’s own view on the three pillars will reveal the level of importance assigned to each risk indicator, which will differ between investors. An appropriate weighting system can then be established based on those preferences to indicate the importance of each ESG risk indicator and metric. The final step is to identify these indicators and metrics within data sources via an appropriate data provider to calculate the overall ESG rating, which will most accurately represent the investor’s own values and industry-specific risks.
Divergence in rating agencies is becoming a serious issue for investors. Capco has a strong record of supporting clients with ESG-related risk frameworks. Our dedicated teams can help you bridge the gap between investment strategies, ESG and data services. We can assist with due diligence of ESG ratings providers as well as with developing customized solutions and selecting data providers to meet your goals.
Contact us to learn more about how we can help your institution on its journey to sustainable change, overcoming any potential challenges to give you an edge over your competition.
Sources
[1] https://www.ussif.org/trends