How Rating Discrepancies Undermine ESG

The environmental, social, and governance (ESG) performance of companies is primarily assessed by six major providers. However, ratings vary considerably from one provider to another, leaving investors with considerable uncertainty as to which one actually meets their personal criteria.

The reason for these differences is the lack of consistency in the data used to construct ESG portfolios across providers. For these reasons, funds may not be aligned with investors’ objectives and beliefs. This also plays into the return and risk associated with ESG funds that depend on specific criteria, reports Larry Swedroe, head of research for Buckingham Strategic Wealth and Buckingham Strategic Partners in Advisor’s Perspectives.

Most institutions rely wholly or partially on external ESG data providers, there is minimal correlation between ESG ratings, reveals the study “Divergent ESG Ratings,” published in the November 2020 issue of The Journal of Portfolio Management.

The ranking of companies varies by provider for the same factor. For example, Facebook is ranked 1st by Sustainalytics for the environmental factor and 96th by MSCI.

This diversity shows the considerable differences between the ratings, reflecting specific company attributes, different terminologies, metrics, and units of measurement. In addition, raters often do not use the same benchmark. For example, Sustainalytics compares companies to components of a broad market index, while S&P compares companies to their industry peers.

In addition, when a company does not disclose metrics, some raters assume the worst and assign a score of zero while others assign a score that reflects that of the peers reporting the data.

“Widespread use of ESG scores is not the answer. At best, they are a starting point. Analysts and fund managers need to understand how they are constructed and supplement them with their own review to build a holistic understanding of a company to ensure that their investments best reflect the values of their end investors,” conclude Elroy Dimson, Paul Marsh, and Mike Staunton, the study’s authors.

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What about returns?

According to the study, there is little evidence that ESG ratings lead to outperformance or underperformance. The authors rely on the 2001 study “Corporate Governance and Equity Prices” by Paul Gompers, Joy Ishii and Andrew Metrick.

This study shows that companies with strong governance in terms of takeover defense and shareholder rights outperformed those with weaker governance by 8.5 percentage points during the decade of the 1990s. But since then, that outperformance has disappeared.

Same thing on the social side, based on the 2015 study “The Wages of Social Responsibility – Where Are They? A Critical Review of ESG Investing”. In this study, outperformance slowly fades over time, as investors would gradually learn over time and markets would become more efficient at ignoring ESG information.

The authors thus expect a similar phenomenon to occur for the environmental factor.

According to some experts, companies with higher sustainability scores have better risk management and compliance standards, leading to fewer extreme events such as environmental disasters, fraud, corruption, and litigation, and thus reduced risk. However, there may be conflicting forces at work.

The first is the fad effect, which leads to short-term capital gains for stocks. But in the long run, that eventually fades, reports Larry Swedroe. And while being a good corporate citizen increases profitability and/or reduces risk, the market quickly incorporates this information into prices, so we shouldn’t expect this factor to bring better returns in the long run, he says.

“For a long-term investor, the perspective we take is that we lack formal evidence that ESG screening improves expected return or reduces risk,” Elroy Dimson, Paul Marsh, and Mike Staunton pointed out.

“For exclusion-based ESG investment strategies, the theory and evidence available so far suggests that the sacrifice made by ESG investors is a slight decrease in expected return and a minor reduction in diversification. The price for ethical principles seems small, and it is a price that many virtuous investors can afford to pay,” they added.

For the time being, however, the market may not have reached a new equilibrium, as increased demand for ESG-style investments continues to drive valuations.

Note that their view is far from shared by all experts. To name just one, recently Desjardins showed that the sacrifice of return often linked to ESG was a myth and that, on the contrary, these investments provided more return due to their better risk management.

However, it is difficult to predict the future. Will this excess return disappear as the market absorbs it? Perhaps, but the other question is, won’t portfolios that don’t take ESG factors into account underperform the market in the long run? What do you think about this?

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(Featured image by geralt via Pixabay)

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