Accurate and consistent data is essential to any robust investment strategy or approach and environmental, social, and governance (ESG) investing is no exception. Yet, much has been made of the challenges of ESG data, which has — according to some studies — hindered adoption of ESG and climate investing. In this piece, we outline how ESG ratings can differ between providers and why investors need to be aware of the implications of choosing a particular ESG data provider.
ESG ratings are used widely by investors to determine how well a company performs on a range of ESG measures, such as climate change, gender diversity or board governance. This information is used by investors prior to investment and in engagement and voting activities, and by companies to improve their ESG practices. Robust and accurate ESG ratings are essential to the ongoing flow of investors capital into sustainable activities and to improve corporate sustainability standards. Yet, ESG ratings are only as accurate as the data that underlie them, and while ESG data quality is continually improving, it is not perfect.
One of the reasons ESG data is in disarray is because companies have not been formally required to report their internal initiatives on ESG factors. Companies are not given formal standards from regulatory agencies as to what ESG data is material (that is, which data influences the long-term value of a company). Instead, they determine for themselves which ESG factors are material and what information should be disclosed to investors. The end result is that companies may selectively self-report ESG metrics to show them in a good light.
Despite the lack of common standards, a plethora of ESG rating providers have emerged in recent years. Well-known ESG data providers with global coverage include MSCI, Sustainalytics, Thomson Reuters, Bloomberg, FTSE, Oekom Research, RepRisk, Inrate, RobecoSAM, and VigeoEIRIS. These ratings providers aim to provide investors with an objective third-party assessment of companies’ ESG performance.
While independent third-party analysis provides an additional assessment beyond solely company self-disclosure, it raises other issues. Over time, each ESG data provider has developed its own sourcing process and research methodology, with no alignment to an overall standard or framework. This has created large discrepancies and divergences in how different ratings providers evaluate the ESG metrics of a company. In a recent paper,1 researchers studied ESG ratings between six ratings providers and found an average correlation of 0.54, far lower than credit rating correlations from credit rating agencies.
The low correlation of ESG ratings between providers was found to be due to three factors:
Scope divergence due to ESG ratings being based on different sets of attributes. For instance, one agency may include lobbying, while another might not, causing the two ratings to diverge. This is because each ESG ratings provider has developed an internal proprietary framework with respect to how it handles materiality.
Measurement divergence where rating agencies measure the same attribute using different indicators. For example, a firm’s labour practices could be evaluated on the basis of workforce turnover or by the number of labour-related court cases against the firm. Both are alternative measures and will lead to different outcomes.
Weights divergence plays a smaller role when rating agencies take different views on the relative importance of attributes. For example, the labour practices indicator may influence the final ESG rating more than the lobbying indicator for some agencies, but not others.
What to Make of Divergent ESG Ratings?
ESG ratings rely on the respective methodology of the vendor at hand. In that sense, they are more akin to recommendations from equity research analysts on company stocks. We would not necessarily expect the same ‘buy, ‘hold’ or ‘sell’ rating from all banks on a particular stock as each analyst has their own models which utilise data in different ways. Hence, a range of ESG ratings simply reflects the broad range of views and methodologies from ratings providers on which ESG metrics (and individual assessments of sub-components) are important.
The lack of consensus on ESG ratings has emerged because there has been no industry standardisation of ESG data. Several bodies including the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI) offer frameworks for ESG company disclosure, yet each has a different scope and emphasis.
For example, the GRI framework has a global scope and focuses on ESG issues that are relevant to stakeholders, whereas SASB adopts a sector-specific approach and addresses only the financial materiality of ESG risks. At the time of writing, the five leading sustainability and integrated reporting bodies are working towards a comprehensive corporate ESG reporting system, but this won’t happen overnight.
Do Your Own Research
Given the lack of ESG data standardisation, asset owners should seek to understand as much as possible about the broad methodology and assumptions their chosen data provider adopts when formulating ESG ratings. We have seen that this should include a review of the scope of ESG data included, which metrics are used, and how ESG scores are aggregated.
This is a real challenge, particularly as various ESG assessment approaches are utilised among different index providers and investment solutions. This has been a particular issue for our clients who have aligned with one ratings provider but who then invest in funds that utilise ESG data from a different ratings provider. For example, analysing an investment proposition utilising ESG data from Vendor A with an analytics tool that is powered by ESG data from Vendor B (or vice versa), will yield non-comparable results.
To make matters more confusing, a recent study2 highlights another potential challenge. Reviewing the history of ESG ratings, researchers found that one provider had continually rewritten their previous ESG ratings. These rewritings affected historical rankings and classifications of firms into ESG quantiles, and the relationship of ESG ratings to returns.
It is possible to subscribe to more than one ESG data provider to gain a more comprehensive picture of company’s ESG risks and opportunities. However, this is an expensive option and one that fails to guarantee a resolution to the ESG data challenge.
To address these issues, we have developed R-Factor™, an ESG scoring system that leverages commonly accepted transparent materiality frameworks to generate a unique ESG score for listed companies. The score is powered by ESG data from four different providers in order to improve overall coverage and remove biases inherent in existing scoring methodologies.
ESG data will not become perfect overnight, so it’s important that asset owners and investors are aware of these challenges before aligning with any one ESG rating provider. Ultimately, there is no substitute for doing your own research and discovering as much as possible about your chosen ESG data provider’s overall approach, methodology and assumptions.
1 Aggregate Confusion: The Divergence of ESG Ratings (Berg, Koelbel and Rigobon, 2020).
2 Rewriting History II: The (Un)Predictable Past of ESG Ratings (Berg, Fabisik and Sautner, 2021).
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