Reliability of ESG Metrics
Differing ESG standards diminish reliability for investors.
By Loan Le
January 7, 2023
ESG investing is an investment approach that considers Environmental, Social, and Governance variables of corporate performance. This investment method relies on third-party ratings to evaluate how companies are doing along ESG dimensions. However, the methods for generating ESG ratings differ greatly among the agencies that create them, with most not exclusively focused on positive impact.
Here we outline how ESG ratings diverge and why that makes the reliability and utility of these ratings questionable.
Evolution of ESG Investing
Beginning in the 1960s, investors sought ways to make an impact with their investments by boycotting certain stocks or industries from their portfolios, also known as socially responsible investing. As socially responsible investments have become more than a player on the sidelines, it has become paramount for companies and industries to adapt. The first ESG index was created in 1990 in response to increasing interest in ESG issues. ESG asset investments have almost doubled from 2015 to 2020 and continue to increase. The significant growth in ESG investing has pushed companies to increase the transparency of their reporting, thereby forcing them to emphasize sustainability in their operations.
There are three main drivers for significant growth in ESG investment since its inception:
1. Changing global landscape
New global challenges include regulatory pressure and a new wave of scrutiny stemming from climate risk, sustainability trends, and demographic shifts.
2. New generation of investors
ESG investing was initially spurred by millennials, who invested close to $51.1 billion in 2020, more than quadrupling from 5 years prior. Sustainable investments now pique interest from all generations.
3. Technological advancements
New tools – such as natural language processing, artificial intelligence, blockchain, and the Internet of Things – have enabled higher quality data collection and analysis than in the past. Consequently, rating agencies and investors have increased trust in the transparency and accuracy of a company’s operational reports.
ESG ratings help asset managers and investors assess the environmental or social risk exposure of a given investment. Companies looking to improve the sustainability of their practices may also consider their ESG ratings. The growing popularity of ESG investments has led to an increase in the number of ESG rating providers – over 160 worldwide – but no standard practice, in turn leading to diverging ratings.
Diverging ESG Ratings
ESG ratings come from independent agencies that evaluate companies on the three environmental, social, and governance components of performance. There are many ESG rating agencies out there, but KLD, Morningstar Sustainalytics, Moody’s ESG (formerly Vigeo-Eiris), Refinitiv (now owned by LSEG; formerly Asset4), S&P Global (formerly RobecoSAM), and MSCI are six well-known agencies currently providing ESG ratings. While all evaluation of ESG performance is based on publicly available data or corporate disclosures, these independent agencies do not have a consistent or standardized method for doing so. Each has its own proprietary algorithms for collecting, categorizing, interpolating, and synthesizing available data into one ESG score.
A research team with MIT Sloan’s Sustainability Initiative calculated an average correlation amongst these rating agencies of only 0.61, far less consistent than the 0.99 correlation between credit ratings from Moody’s and Standard & Poor’s.
A recent paper reports finding three primary drivers of ESG rating divergence between the agencies:
Scope contributes to divergence at 38%
- Rating agencies take into account varying factors (e.g., lobbying, human rights, employee turnover, greenhouse gas emissions). Some may include factors that others don’t.
Weight is the smallest contributor to ESG divergence at 6%
- Rating agencies may give different weights of importance to the factors included in a score. For example, one agency could consider greenhouse gas emissions to be significantly more important than employee turnover, while another agency gives different weights to these factors.
Measurement is the largest contributor to total ESG divergence at 56%
- Within each factor, the rating agencies could use different raw data or metrics derived from that data to calculate a score. For example, an evaluation of labor practices could be based on the number of labor cases, workforce turnover, or both. Agencies also have different methods of dealing with missing data. The differing data that comprise an individual factor can cause significant deviation in rating scores.
- Within the measurement category, rater biases also contribute significantly to variation in ESG scores. For example, raters who view a company positively for one factor will likely judge other factors positively as well.
Comparing two downloads of the same Refinitiv ESG rating database from 2018 (the initial version) and 2020 (the rewritten version), the study found that historical ratings in the rewritten version were retroactively adjusted, supposedly reflecting changes in Refinitiv’s scoring methodology. In the initial database, there was no correlation between ESG ratings and market performance. However, in the rewritten version, companies rated higher outperformed companies with lower ratings.
Retroactive revision of historical scores is something investors should take into account when assessing the market performance of a rating agency’s scores.
Divergence Implications
Regardless of the scoring mechanisms, diverging ESG scores can cause several problems, such as:
- Biases from raters and agencies decrease the overall reliability of ESG scores.
- Inconsistencies in ESG scores cause confusion, relaying unnecessary noise in the sector that should be a sounding board to those who use it to make investments.
- Companies seeking to improve their ESG profile may struggle to fully assess what factors to focus on in evaluating their strengths and shortcomings.
As an example of the disagreement among rating agencies, Chevron currently received a “high risk” score from Sustainalytics, yet is categorized as only “average risk” by MSCI. By all accounts, Chevron is a fossil fuel company - with disclosed emissions of 697 million tons of carbon dioxide equivalent in 2019, and no concrete plan to reduce emissions. Both rating agencies are well-respected and credible, yet according to MSCI, Chevron might be classified as a sustainable investment. Moreover, it’s difficult to compare the differing scales of Sustainalytics (0 to 40+ scale) and MSCI (letter grades). Any attempt to dig deeper meets with opaque descriptions of their methods.
The discrepancies in ESG ratings amongst agencies particularly impede decision-making for individual investors, who have fewer tools than investment firms to research and interpret ratings from different rating agencies. As the ESG field is still evolving, those who use ESG ratings in their decision-making process should anticipate further changes until institutions such as the SEC decide on more stringent regulations.
Alternatives to ESG Investing
While ESG ratings serve as a starting point for those seeking to invest sustainably, GreenPortfolio cautions investors to do extensive research to avoid potential greenwashing.
Impact Investing could be an alternative solution for individual investors. The Global Impact Investing Network (GIIN) summarizes the four core characteristics of impact investing as (1) intentionality, (2) evidence-based decision making, (3) performance of investment, and (4) advancement of the impact investment industry. Investing with these goals in mind generates beneficial social or environmental impact alongside financial returns. Similar to ESG investing, there is no standard definition of “impact,” so investors must perform their own due diligence.
For the greatest impact on issues of climate change, another alternative is directly investing in renewable energy projects via stocks, bonds, and other financial instruments. Although this approach entails a little more legwork, it enables individual investors to have a more reliable impact on climate change with their investments.
GreenPortfolio can help individual investors take climate action with their finances. Take a look at our list of climate-friendly mutual funds, ETFs, and bond funds to get started today.
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