ESG ratings – friend or foe?

What are the factors driving counter-intuitive outcomes?

With Environmental, Social and Governance (ESG) aspects entering the mainstream investment arena, the use of ESG ratings has increased sharply, becoming an important aspect in security, fund and mandate selection. As a result, there has been strong growth in the number of ESG rating and data providers. In practice, ESG ratings do come with several important challenges that are essential for asset owners and asset managers to be aware of when assessing the sustainability of securities, funds and mandates.

As an example, a recent check with one of the ESG rating agencies showed that a large traditional oil & gas company scored better on ESG compared to a mid-cap renewable energy company. So what are the factors driving these counter-intuitive outcomes?

Be aware of size biases

First, ESG ratings often display a size bias such that larger firms have, on average, better ESG scores. This does not necessarily mean larger companies take better care of the environment or society. More often it is the result of larger companies having more resources to develop and report on their ESG policies and activities. The size bias seems to suggest that some ESG scoring methodologies still look for an important part to policies, more than the actual behavior or products of these companies.

Sector neutrality can lead to counter-intuitive results

Secondly, most ESG scoring methodologies still include some kind of sector-neutrality, meaning that in every sector there are companies that score well on ESG and companies that score poorly on ESG, irrespective of the sector these companies are active in. A clear conflict with sustainability could arises as also companies active in sectors that are not really seen as sustainable, such as weapons, tobacco and traditional energy, can still get high, above market-average ESG scores driven by its policies and this sector-neutrality feature. 

Correlation is low between ESG rating agencies

Third, the correlation between ESG scores of different data providers is often low. CSRHub showed that correlation between the different ratings agency’s ESG scores can be as low as 0.3, clearly showing the lack of consistency. A recent study by the Massachusetts Institute of Technology (MIT) also highlighted this discrepancy. This illustrates that ESG scores are subjective, partly due to the different methodologies applied. It is important to stress that this observation doesn’t change the fact that the insights and arguments that lie behind these scores can still be a valuable input in the investment process. The observation simply shows that opinions can differ, like we also see with sell-side research where there are different ratings on the same security.  

Ratings are fairly stale over time

Fourthly, ESG scores of the traditional ESG rating agencies are fairly stale through time. In other words, a company’s ESG score today is fairly comparable, on average, to its score from 3 years ago. This can be partly the result of infrequent review cycles and the fact that specific ESG data points don’t tend to change much. However, there is a risk that therefore changes in underlying ESG trends might take some time to show up in ESG ratings. As a result, new ESG rating agencies are emerging that, by using new technologies, focus more on timely, newsflow-driven ESG data, leading to more frequent updates.

Reporting standards are still mostly absent

Fifth, collecting high quality and comprehensive data remains a challenge. A key reason for this is that it is not mandatory for companies to report on most types of ESG data. Although companies may well volunteer ESG information, this often lacks consistency because regulators do not stipulate standards to the same degree that they demand financial data, for example.

Addressing the pitfalls

Several measures can be taken to address the pitfalls presented by ESG scores when making investment decisions or judging the “sustainability” of an investment fund.

First, it is important to realize that ESG ratings are not facts but opinions. Asset owners and managers should always treat such ratings as just the starting point in any investment process. Understanding the viewpoints on which ESG ratings are based is key.

Second, diversity of thought is key to tackling the differences in methodology, lack of timeliness and the low correlations between ESG data providers. Combining different ESG sources, including in-house analysis if possible, can enrich insights and analysis and improve active decision-making.

“There continue to be several pitfalls to be very mindful of when using ESG scores for stock selection, portfolio construction or fund selection”

Third, it is important to focus on ESG aspects that are material i.e. aspects that have an impact on the longer-term cash flow-generating ability of a company and hence its longer-term share price. Frameworks such as those developed by the Sustainability Accounting Standards Board provide great insights on a sectoral basis for this. Focusing on materiality ensures good alignment between ESG integration and improving the risk-adjusted returns of an investment portfolio.

Fourth, to maximise the positive impact on risk-adjusted returns it is advisable to focus on a company’s behavior and its improvement momentum rather than its stated policies. For a long time, the latter was a key focus of ESG rating agencies but in the last few years, research has emerged that shows that companies that are improving their ESG credentials display better risk-adjusted financial returns.

Fifth, asset managers and owners can significantly aid improvement in ESG data by engaging with corporates. The more requests from financiers, the more likely corporates are to act and improve disclosures.

Lastly, the use of new technologies such as natural language processing, machine learning and Artificial Intelligence could improve ESG insights further, helping to both complete data sets and improve their timeliness and quality.

ESG ratings can still provide valuable insights

In conclusion, ESG scores have come a long way with quality gradually improving towards more material and behavioral-based scores versus the more traditional policy-based scores. Still, there continue to be several pitfalls to be very mindful of when using ESG scores for stock selection, portfolio construction or fund selection. Addressing these in the right way and looking what’s behind these scores can still help you improve your decision-making process. 

Jeroen Bos is Head of Specialised Equity & Responsible Investing at NN Investment Partners.