ESG ratings should not be viewed as objective ratings but as opinions, experts have said.
Will Collins-Dean, and Eric Geffroy, a senior portfolio manager and investment strategist respectively at Dimensional Fund Advisers, said given the “subjectivity inherent in ESG ratings”, they should be viewed as opinions, similar to the buy, hold or sell opinions used by sell-side analysts.
“When using ESG ratings from one provider to allocate assets, investors should be aware that other ratings providers may have dramatically different opinions and ratings," they said.
Rating provider firms routinely rate firms on the ESG credentials, giving them ratings such as “AAA” for the best and “CCC” for the worst.
The problem with this, the pair said, is that these providers are looking at hundreds of “reported and estimated” variables for a single firm, boiling them down to a single ESG rating.
Furthermore, ESG providers frequently disagree on company ratings.
Collins-Dean and Geffroy referenced a chart first published by Boffo and Patalano of the OECD, ‘ESG Investing: Practices, Progress and Challenges’, that shows the correlation between different scores given to the same firms by different providers.
“The correlation between the ESG scores of different ESG ratings providers has been estimated at 0.54, and even lower when looking at the individual E, S, and G pillars.
“It is common for a company to be identified as best-in-class by one provider and as just average by another provider.”
Examples of ESG rating discrepancy
Sorce: Boffo and Patalano, OECD (2020)
The issue is that the sources of these ratings differ in what they measure, how they measure and what weight is assigned to each variable.
Because the ratings look at so many variables, and because ratings providers generally do not publish their methodology, it is hard to understand where the discrepancies might come from, the pair said.
“This complexity means that ESG ratings may not be effective at achieving, and sometimes even work against, the sustainability objectives of investors.”
The way to solve this is for investors to first identify which specific ESG considerations are important to them, and then chose an investment strategy accordingly, they said.
The broader the set of objectives though, the more difficult it would be to manage them, they added. “A 'kitchen sink' approach that integrates dozens of variables may make it hard for investors to understand a portfolio’s allocations and may lead to unintended outcomes.”
Investors should also look closely at the data.
“Not all ESG data are created equal, and certain disclosures are more reliable and robust than others,” the pair said.
For instance, data that rely on voluntary surveys might inadvertently favour large companies with well-staffed reporting teams, regardless of their actual ESG performance.
“Equally important is the ability of managers and fiduciaries to deliver meaningful sustainability reporting to their clients.
“Investment professionals should be confident that the ESG data they use can support the value proposition they seek to deliver to their clients.”