The arbitrary nature of ESG ratings is exemplified by various studies that pinpoint the low correlation in ratings from various agencies.
With trillions of dollars pledged to encourage sustainable practices, shifting demographic trends, and a new thrust on the growing importance of non-financial data, responsible investing is here to stay. As one would expect, there is a bee line of service providers to support this promising trend. There are already over 20 compilers of ESG data worldwide as compared to a few on the more established credit ratings. There is no doubt that the global effort to integrate ESG in investment decisions is sincere at many levels. However, there’s already much criticism floating in the air for these ESG ratings.
There is no generally accepted methodology for ESG evaluation and rating. The arbitrary nature of ESG ratings is exemplified by various studies that pinpoint the low correlation in ratings from various agencies. As per research studies, the correlation of ESG ratings is quite weak between 0.4 to 0.6 in contrast to the correlation of credit ratings which is quite strong at 0.9. The disparity in views among rating agencies is equally dramatic at both the aggregate as well as underlying ESG level. This implies that the source of the discrepancy is not only the weighting of the factors but also in the variation of factor definitions and metrics. Researchers at MIT Sloan characterized this effect as “aggregate confusion”.
ESG ratings disagreement study on S&P 500 firms between 2013 and 2017 and use ESG ratings data from six prominent providers: Asset4 (now Refinitiv ESG), Sustainalytics, Inrate, Bloomberg, MSCI KLD, and MSCI IVA.
Disparity is though not the biggest worry. At least it allows you to inquire and reach logical conclusion. The real problem lies when there’s consensus. In 2014, when Quantum was looking to progressively expand its Governance integrity evaluation to a more holistic ESG recognition of companies, it did approach a few rating providers to assess their work on ESG. And, to our surprise, there were positive / investment grade ratings on some companies which wouldn’t even pass our integrity filter. A company that’s not good at the Governance aspect will generally be poor on on environment and social performance.
Just to quote one instance. Most of the ESG ratings were positive, though not the best, on one of the largest index heavyweights in many India indices”. We have had concerns with the Governance practices of the company. Broad areas of concerns range from related party transactions, shareholder rights, financial audit and operations, Board and Management structure, corporate responsibility to business ethics. Given that it’s a large company from a market capitalization perspective, is that a consideration so that ESG indices can include it and show more capacity? Investors glossing over these issues and blindly aligning their strategies to a rating agency may end up with a portfolio of companies that can be tagged “ESG” but might not be that in essence, defeating the purpose.
Quantum would never compromise on Governance. That is when we decided to respond to this lacuna by developing our own framework to rate and rank stocks according to ESG metrics that comprehend and capture the sustainability framework in a rightful manner.
Quantum’s ESG Approach:
- Our analysis is guided by the materiality of the issues
- Governance is the most important element in our assessment.
- Typically focus on areas such as long term capital allocation, board composition, quality of disclosures and treatment of minority shareholders
- Shortcomings go hand in hand with poor performance on the social and environmental fronts, making it a good proxy for wider problems
- Identify companies that can act as long term stewards of capital
Our thought process has evolved over last few years, traversing through our own learning curve to establish principles-based, quality-oriented ESG framework. We are sure that this evolution process will continue to evolve to aim for perfection. We are also confident that with our process, one can reduce the risks of being in companies with poor governance, questionable social practices or cause dangerous environmental destruction.
While banking on sustainability / Governance, using the right ESG framework is the way forward, the risk is that the stakeholders in their foot thumping march towards responsible investing, will lose sight of the fundamental issues on ESG integrity.
