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Why Are Billions of Dollars Contingent on ESG?

ESG ratings can heavily influence investor’s choices and favour some companies over others which can result in shifting billions of dollars between these companies. It is therefore important to ask the following question: are there differences between the same grade ratings?
Environmental , social, and governance (ESG) rating providers have become influential institutions. Investors with over $80 trillion in combined assets have signed a commitment to integrate ESG information into their investment decisions (PRI, 2018). ESG ratings can heavily influence investor’s choices and favor some companies over others which can result in shifting billions of dollars between these companies. If investors do not know the full methodology and reasons for why some companies have better ratings than others, then their investments (and therefore billions of dollars) are only determined by a 1 to 3 letter edict. It is therefore important to ask the following questions: are there differences between the same grade ratings? If yes, what are the reasons for the divergences?
Research performed by Florian Berg and his team from the MIT Sloan School of Management explores divergences of environmental, social, and governance (ESG) ratings and their inherent reasons. This is done by comparing data from six prominent rating agencies: KLD (MSCI Stats), Sustainalytics, Vigeo Eiris (Moody’s), robecosam (S&P Global), Asset4 (Refinitiv), and MSCI . To analyze the data researchers have developed a consistent framework that reveals in detail how much and for what reason ratings differ. The framework has pointed out three distinct sources of divergence:
  1. Scope divergence refers to the situation where ratings are based on different sets of attributes. Attributes such as carbon emissions, labor practices, and lobbying activities may, for instance, be included in the scope of a rating. One rating agency may include lobbying activities, while another might not, causing the two ratings to diverge.
  2. Measurement divergence refers to a situation where rating agencies measure the same attribute using different indicators. For example, a firm’s labor practices could be evaluated based on workforce turnover, or by the number of labor-related court cases taken against the firm.
  3. Weights divergence emerges when rating agencies take different views on the relative importance of attributes.
Findings show that measurement divergence is the main driver of rating divergence, closely followed by scope divergence, while weight divergence plays a minor role. Measurement divergence implies that even if two raters were to agree on a set of attributes, different approaches to measurement would still lead to diverging ratings. Slightly less important is scope divergence, i.e. Raters consider certain categories that others do not. For example, a company’s lobbying activities are considered only by two out of the six raters in our sample. The least important type of divergence is weights divergence, i.e. Disagreement about the relative weights of categories.
A firm’s category scores depend on the firm itself, on the rating agency, and the category being rated. Raters’ assessments are correlated across categories so that when a rating agency gives a company a good score in one category, it tends to give that company good scores in other categories too. Different raters measure the performance of the same firm in the same category differently. ESG rating divergence is not merely driven by differences in opinions, but also by disagreements about underlying data. Certain results that have been obtained based on one ESG rating might not be replicable with the ESG ratings of another rating agency.
For investors, it is useful to understand why a company has received different ratings from different rating agencies. Alternatively, investors might rely on one rating agency, after convincing themselves that scope, measurement, and weights are aligned with their objectives.
For companies, the results show that there is substantial disagreement about their ESG performance. This divergence occurs not only at the aggregate level but is even more pronounced in specific sub-categories of ESG performance, such as Human Rights or Energy. This situation presents a challenge for companies because improving scores with one rating provider will not necessarily result in improved scores at another. Thus, ESG ratings do not, currently, play as important a role as they could in guiding companies toward improvement. An example of disagreements and divergences can be seen in Figure 1.
Figure 1. Arithmetic decomposition of the difference between two ESG ratings, provided by Asset4 and KLD, for Barrick Gold Corporation in 2014. The normalized ratings are on the left and right. The overall divergence is separated into the contributions of scope divergence, measurement divergence, and weights divergence. Within each source, the three most relevant categories in absolute terms are shown in descending order, with the remainder of the total value of each source labeled as “Other”. The residual between the original rating and our fitted rating is shown in the second bar from the left and from the right, respectively. [1]
To change this situation, companies should work with rating agencies to establish open and transparent disclosure standards, and ensure that the data that they themselves disclose is publicly accessible Finally, rating agencies should seek to understand what drives the rater effect, in order to avoid potential biases. Three major consequences follow:
  1. Varying ESG performance ratings may influence asset prices.
  2. The divergence hampers the ambition of companies to improve their ESG performance because they receive mixed signals from rating agencies about which actions are expected and will be valued by the market.
  3. The divergence of ratings poses a challenge for empirical research, as using one rater versus another may alter a study’s results and conclusions.
Taken together, the ambiguity around ESG ratings represents a challenge for decision-makers trying to contribute to an environmentally sustainable and socially just economy. Results call for greater transparency from the rating agencies. The agencies should communicate their definition of ESG performance in terms of scope of attributes and aggregation rule. With that in mind, the rated firms would have clearer signals about what is expected of them, and investors could determine more precisely whether ESG ratings are aligned with their objectives.

References

[1] Berg, Florian, and Kölbel, Julian and Rigobon, Roberto, Aggregate Confusion: The Divergence of ESG Ratings (May 17, 2020). http://dx.doi.org/10.2139/ssrn.3438533
[2] PRI. PRI Annual Report, 2018.

About the author:

Mijat Kustudic is a researcher and scholar with focus on finance and A.I. He is also a seasoned project manager in sustainability and has participated in numerous initiatives across Europe, Africa, and Asia.

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Why Are Billions of Dollars Contingent on ESG?

ESG ratings can heavily influence investor’s choices and favour some companies over others which can result in shifting billions of dollars between these companies. It is therefore important to ask the following question: are there differences between the same grade ratings?

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