ESG News ESG SCORES: NOT HIGHLY RATED
Sustainability scores diverge hugely, making it difficult for investors to assess a company’s ESG profile. Andrew Holt reports.
A study has found a significant divergence in ESG scores from six prominent rating agencies, which has big consequences for investors.
This is the main finding of a report – Aggregate Confusion: The Divergence of ESG Ratings – published by academics from the Massachusetts Institute of Technology (MIT). The team inves- tigated the divergence of ESG ratings based on data from six prominent agencies: KLD, Sustainalytics, Moody’s ESG, S&P Global, Refinitiv and MSCI.
They found that ESG ratings on the same company can vary substantially, with these disagreements having a number of important consequences, warned the report.
Primary failure First, such a divergence in scoring makes it difficult to evaluate the ESG performance of companies, funds and portfolios, which is the primary purpose of ESG ratings. Second, ESG rating divergence decreases companies’ incen- tives to improve their ESG performance. “Companies receive mixed signals from rating agencies about which actions are expected and will be valued by the market. This might lead to under-investment in ESG improvement activities ex-ante,” the report read.
Third, markets are less likely to price firms’ ESG performance ex-post, that is after actual returns have been achieved and the ESG performance may be fundamentally value-relevant or affect asset prices through investor tastes. “However, in both cases, the divergence of the ratings disperses the effect of ESG performance on asset prices,” the report added. Fourth, the disagreement shows that it is difficult to link CEO compensation to ESG performance. The report said: “Con- tracts are likely to be incomplete, and CEOs may optimise for one particular rating while underperforming in other impor- tant ESG issues – that is, CEOs might hit the target set by the rating but miss the point of improving the firm’s ESG perfor- mance more broadly.”
ESG challenge Finally, the divergence of ratings poses a challenge for empiri- cal research, as using one agency versus another may alter a study’s results and conclusions. “The divergence of ESG rat- ings introduces uncertainty into decisions taken based on them and, therefore, represents a challenge for a wide range of decision-makers,” the report said.
28 | portfolio institutional | July–August 2022 | issue 115
It presents a challenging picture for investors, who are consist- ently wanting to show their commitment to ESG. But how can they do so convincingly when the scoring situation is such a contradictory mess? For all of this, the report concludes that ESG ratings can still be some use. “ESG rating divergence does not imply that measur- ing ESG performance is a futile exercise,” the report said. “However, it highlights that measuring ESG performance is challenging, that attention to the underlying data is essential, and that the use of ESG ratings and metrics must be carefully considered for each application,” the report added. Ken Pucker, an ESG and sustainability senior lecturer at the Fletcher School at Tufts University in Massachusetts, is much more critical – and has long identified this as a problem. “ESG rating firms take self-reported data from companies on their corporate social responsibility [CSR] activities, add their own information and weightings, and mix it in a cauldron to come out with a rating for a company. “A problem is garbage in, garbage out,” Pucker added. “The reporting is not complete, results are mostly unaudited, and they are not comparable, so ESG ratings often use bad data that’s unaudited, extrapolated and interpolated.”
Just one
The report recommends how investors could obtain a better ESG scoring picture. “Investors could reduce the discrepancy between ratings by obtaining indicator-level data from several raters and then imposing their own scope and weight,” it said. But this would be a time consuming for investors and not easy to undertake. The paper presents a second option for investors to consider. “Alternatively, investors might rely on one rating agency after convincing themselves that scope, measurement and weight are aligned with their objectives.” The paper adds another recommendation: “A taxonomy of ESG categories would make it easier to contrast and compare ratings.”
To be clear
The MIT report concludes on calling for greater transparency on behalf of rating agencies. “First, ESG rating agencies should clearly communicate their definition of ESG performance in terms of scope of attributes and aggregation rules. “Second, rating agencies should become much more transpar- ent with regard to their measurement practices and methodol- ogies. Greater methods of transparency would allow investors and other stakeholders, such as rated firms, NGOs and aca- demics to evaluate and cross-check the agencies’ measurements.”
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