CUHK Business School Research Finds the Inconsistent ESG Scores from Different Rating Agencies Decreased Investor Demand for Green Stocks APN NewsRead More
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Corporate News Previous story Daddy Jones Bar & Restaurant opens a Coffee Shop. It is available for takeout and patio dining on Saturday and on Sunday. Next story: CUHK Research Finds Inconsistent ESG Scores From Different Rating Agencies Decreased Investor Interest for Green Stocks Published September 24, 2021 HONGKONG SAR : Sustainable investment, once considered an anomaly maybe ten years ago, is now more popular than ever. According to Morningstar, the U.S. attracted nearly US$2 trillion of investment in the first quarter 2021. ESG (environmental social and governance) investment is growing in demand. Therefore, it is important to have better quality ESG performance data. A recent research study found that ESG ratings provided by different agencies can cause confusion for investors and prevent the sustainable investment sector reaching its full potential. It is not unusual for ESG rating providers to have widely different ratings. Sustainalytics categorizes Tesla Inc. as high risk, but it rates Tesla Inc. as average in its ESG ratings. Source: iStock. Sustainable investing, also known by ESG investing or socially-responsible investing, asks investors to consider a company’s ESG profile and financials before making an investment decision. These additional factors include everything from the company’s energy use, pollution, and working conditions to its participation in its community and diversity on its board of directors. Because of these considerations, it is not unusual for sustainability-minded investors to set maximum thresholds or even shy away altogether from less “ethical” sectors such as coal, defence, gaming or tobacco. The U.N. was the first to coin the term ESG investing, perhaps due to its recent introduction in finance. Global Compact was part of a landmark 2004 study called Who Cares Wins. However, there is no standard or common method for calculating ESG ratings between different agencies. KPMG estimates that there will be 30 major ESG data sources worldwide by 2020. These rating agencies often use different methods to calculate their ESG scores. It is not unusual for them to give different ESG ratings for the exact same company. Sustainalytics categorizes Tesla Inc. as high risk, but it rates Tesla Inc. average in its ESG ratings. Si Cheng, Assistant Professor in Finance at The Chinese University of Hong Kong Business School, Prof. DoronAvramov at IDC Herzliya and Prof. Abraham Lioui respectively at EDHEC Business School, conducted the new study Sustainable Investing With ESG Rating Uncertainty. Prof. Cheng and her coauthors tested their hypothesis with U.S. stocks between 2002 and 2019. They also examined the ratings of six major ESG rating agencies – Asset4(Refinitiv), MSCI KLD and MSCI IVA as well as Sustainalytics, RobecoSAM, RobecoSAM, Sustainalytics, Bloomberg, Sustainalytics, Sustainalytics, and Bloomberg. The research team found significant disparities across different ESG rating providers, in line with previous studies. The confusion among the ESG rating agencies’ ratings made sustainable investing more risky and decreased investor demand for stocks. Ratings disagreement “Generally, there is a lack consensus in reporting, measuring, and interpreting ESG information. There are a lot of ESG data on firms, which can be both overwhelming and perplexing. Prof. Cheng explains that investors may have difficulty determining the true colour of a firm’s business, whether it’s green, brown or somewhere in between. This in turn feeds into investor interest in sustainable investment. Investors who are looking for ESG plays but aren’t sure about the sustainability of the stock in which they plan to invest money will likely reconsider their decision. The researchers used data from six ESG rating agencies to generate an ESG score for each stock. They also calculated a score to determine the difference between the ESG scores of the six agencies to calculate the level uncertainty in ESG ratings. The results show that the average rating correlation is only 0.48 and the average ESG rating uncertainty of 0.18. This means that a company can be ranked in either the 59th or bottom third by different data providers. These scores were used by researchers to examine how inconsistency between ESG ratings could affect whether institutional owners would invest in a stock and its actual performance on the stock market. The study examined three types of investors. The first category includes pension funds and university and foundation endowments. These institutions are required to invest in socially acceptable ways, such as socially responsible investing. This is in contrast to other institutional investors, who are more interested in financial returns. The study showed that institutions with higher investment norms were more likely to favor greener firms. However, they were less likely than other institutional investors to hold green stocks if there was high inconsistency in ESG ratings. Companies with the highest ESG scores hold on average 22.8 percent of their shares. However, this is only true if the ratings given by different ESG agencies are in high agreement. Institutional ownership dropped to 18.1 per cent when the correlation between ESG ratings from different rating agencies was low. Hedge funds, on the other hand, invest more in brown stocks, and rating uncertainty most often affects their holdings of brown stocks. The researchers found that hedge funds owned an average 15.7 percent share of companies with the lowest ESG scores. This was when there was high agreement among the ESG scores of different rating agencies. When the ratings of different agencies were not in agreement, this dropped to 13 percent. According to the authors, investors in their preferred investment universe are most concerned about rating uncertainty. Companies that focus on improving their ESG performance will be expected to deliver lower investment returns, as they offer non-pecuniary benefits for investors. However, the study found that this is not always true. It found that brown stocks outperform green stocks when ESG ratings are low. Brown stocks outperform green stocks by 0.59 percent per monthly in absolute returns and 0.40% per month in risk-adjusted return when there is high agreement between ratings from different ESG rating agencies. However, inconsistent ESG ratings can lead to a decrease in stock performance and a disconnect between company’s ESG leanings. Market Implications The study also suggests that ESG ratings ambiguity has an overall effect on the stock market. A higher level of ratings confusion is associated with a higher market premium, lower stock market participation, and lower economic welfare for ESG sensitive investors. ESG rating confusion can be particularly damaging to green stocks. Rating agencies may penalize firms that take a more responsible approach to their operations if they fail to agree on their ESG profile. This would limit their ability to invest capital and make a real impact on society. Prof. Cheng says that ESG-sensitive investors are equally likely to cease making ESG investments in companies with uncertain ESG profiles. The study findings have important implications for asset pricing, investor welfare, asset allocation, and investor welfare. Prof. Cheng and her coauthors recommend that companies provide more detailed reports on their ESG performance in order to minimize the negative impact of ESG investing through rating inconsistency. Researchers recommend that ESG rating agencies release more information about their measurement methods and methodologies. They also believe that there should be more public discussion about how companies can measure ESG performance. “Sustainable investment is on the rise. Prof. Cheng explains that the overall impact of ESG rating inconsistency “will become more prominent.”