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Do ESG Ratings Get High Marks? WealthManagement.comRead More
The volume of sustainability data is increasing rapidly. For example, almost all public companies now report or estimate greenhouse gas emissions. Investors who wish to allocate funds to companies based on carbon footprints will be happy to hear this.
Beyond the increased number of company sustainability data, there are significant challenges. Corporate sustainability reports can be a hundred pages long and vary from one company to another. They may not contain all the information that investors are looking for. Investors naturally seek out help in understanding ESG data.
The ESG Ratings Shortcut
Related: September ESG Quick 5ESG ratings may seem promising at first to help navigate this complexity. ESG rating providers may examine hundreds of variables reported and estimated for a single company, and then distill them into a single ESG rating. Individual company ratings can then be combined into fund and index ratings, or scores. ESG ratings have gained popularity due to their ease of use in recent years.
Regulators around the world have expressed caution. Jay Clayton, then-SEC Chairman, stated in 2020 that he had “not seen circumstances” where E, S and G could be combined across a wide range of companies. This would allow for meaningful investment analysis that wasn’t over-inclusive or imprecise.
Related: What Financial Advisors Should Know About ESG Rating Systems. Beauty is in the eyes of the beholder. Sustainability is often a subjective concept. ESG rating providers often disagree on company ratings. The correlation between ESG scores from different ESG rating providers has been calculated at 0.54 and even lower when considering the individual E, S and G pillars. It is not uncommon for a company being identified as best-in class by one provider but as average by another provider. The correlation between the credit ratings assigned to companies by Moody’s or S&P is 0.99. These findings are consistent in Dimson, Marsh, Staunton (2020). Boffo and Patalano (2020) provide examples of companies that have high levels of disagreement.
There are many factors that can cause dispersion in ESG ratings. These include differences in how the variable is measured and how it is measured. It can be difficult to understand the source of discrepancies in ESG ratings, which often consider dozens of variables. Also, detailed methodologies and score attributions are not generally available.
This complexity means that ESG rating may not be able to achieve, or sometimes even work against, investors’ sustainability objectives. A recent OECD study showed a low correlation between ESG scores and E pillar scores for three rating agencies. It also found a positive correlation between E pillar scores for carbon emissions for two of the three rating providers. This means that a high environmental rating was associated not with emitting less but more. Dimensional’s research also revealed a statistic that could give environmentally-minded investors cause for concern. Our 2021 study reveals that sustainability funds have a wide range of emissions reduction strategies. Only 14% of US-domiciled funds branded as “sustainability,” reduce greenhouse gas emissions by 11% or less than the Russell 3000.
We believe that ESG ratings should not be considered objective ratings because of the subjectivity they contain. Instead, they should be viewed as opinions, similar to the buy/hold/sell opinions issued by sell-side analysts over the years. Investors should be aware of the possibility that ESG ratings from different providers could have drastically different ratings and opinions when allocating assets.
ESG ratings can cause indices to differ from one another. The MSCI World SRI Index, which focuses on companies with strong ESG ratings and assigns a weight of over 12% to Microsoft as of March 2021, was nearly four times the weight of its market capitalization weight. However, it did not include Alphabet or Apple. The FTSE Developed ESG Index had all three companies overweighted. Investors need to understand how investment decisions are made. However, the complexity, opacity and subjectivity of ESG rating methodologies can make it difficult for them to do so.
From ESG Data to Robust Strategies
Instead of using generic ESG ratings, investors should first identify the ESG considerations that are most important to them and then choose an investment strategy. One example might be reducing exposure companies with high emissions intensity. The more objectives you have, the more complicated it is to manage their interactions. Investors may find it difficult to understand the allocations of a portfolio’s variables if they use a “kitchen sink” approach. This could lead to unintended consequences.
Investors should take a closer look at the data. ESG data is not all created equal. Some disclosures are more reliable or robust than others. Data that is based on voluntary surveys can inadvertently favor large companies that have well-staffed reporting departments, regardless of their actual ESG performance. Managers and fiduciaries must be able to provide meaningful sustainability reporting to clients. Investment professionals need to be confident that the ESG data used can support the value proposition that they want to deliver to clients.
Will Collins-Dean, Vice President and Senior Portfolio manager at Dimensional Fund Advisors, is Will Collins-Dean