Are ESG ratings too subjective to be useful?

Analysis of one provider's scoring suggests problems with year-on-year comparisons and sector exposures

Are ESG ratings too subjective to be useful?

In the face of undeniable demand among investors, ESG data providers are rushing in to fill the as-yet unsatisfied need to perfectly assess companies’ performance on environmental, social, and governance factors. But if one analysis of ratings is anything to go by, investors will have to wait a while before they have a true gold standard for ESG evaluation.

In a piece written for ETFStream, FactorResearch founder and CEO Nicholas Rabener said there are currently more than 600 ESG rating frameworks for investors to choose from, as per the think tank SustainAbility. And since not all data providers have the same methodology, it can be difficult for investors to evaluate all their options.

“It is precisely because of the strong momentum of the ESG industry that investors need to be cautious in evaluating ESG data, which has become increasingly complex given the abundance of options,” Rabener said.

Focusing on one unnamed provider, he said the number of U.S. stock issuers with ESG ratings has risen from 20 in the year 2000 to around 800 in 2020, covering almost all member stocks of the S&P 500. Over that same time, the average ESG rating has risen from 25 to 50, which Rabener attributed to the wider availability of ESG-related data.

“Unfortunately, this implies that year-to-year comparisons are not that useful and ratings should only be evaluated on a cross-sectional, relative basis within a year, which increases the complexity of using ESG data,” he said.

Asset managers have traditionally used ESG data to adopt exclusion strategies, with low-rating stocks being screened from their portfolios, but the large tracking errors created by the approach have made it less popular in recent years. Weighting stocks by ESG scores also opens the door to tracking error as higher-scoring stocks tend to have an outsized influence on performance, which is why there’s been a move toward ESG incorporation at the sector level.

“However, although this minimises tracking errors, it does lead to exposure to undesired sectors like energy,” Rabener said. “Asset managers can only hope that clients do not look too closely at the breakdown by sectors in marketing materials … Fossil-free is not always 100% fossil-free.”

Looking at average ESG ratings on a per-sector basis also showed an inconsistent picture, with energy and materials companies featuring high average ratings even as those stocks typically go to the bottom due to their low environmental scores.

“[T]his data provider calculates ESG scores on a range from 0-100 and sector-neutral, but it is difficult to explain why utility stocks have an almost 100% higher ESG score than communication stocks on average,” Rabener said. “Perhaps this is an indication of companies starting to game the ESG ecosystem, e.g. by disclosing more or only selective information.”


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