As organizations & investors continue to focus on the impact that Environmental, Social, & Governance (ESG) factors have on their performance; companies who rate and provide “ESG ratings” have cropped up everywhere. ESG ratings are now being used by investors to make pivotal decisions on whether a company is sustainable or socially responsible.
Similar to the challenges of how to disclose ESG efforts of an organization, there are significant challenges with how to rate them. Each rater has different rating scales and scoring methods. Some measure a company’s exposure to ESG risk while others measure a company as leading or lagging in ESG. Additionally, some ratings are in the form of numerical scores, some use grade ratings, and each has a different rating scale.
Can these ratings truly be used to improve decision making on whether a company is environmentally & socially responsible? How are these raters assessing a company? And are they looking at relevant factors for the company and industry to come up with their final score? Without a doubt the rating companies are putting in a lot of effort, data, and complex calculations into generating their scores. But there is still the nagging question...is it truly accurate, or does a deeper, independent analysis need to be taken into account when making an investment decision?
divergence in the ratings
A 2020 study by MIT Sloan, titled ‘Aggregate Confusion: The Divergence of ESG Ratings’ looked at 6 top ESG Rating organizations* and their ratings of companies and found an average correlation of 0.61 between the ratings. If you compare this to the correlation between credit rating agencies, such as Moody’s and Standard & Poor’s their ratings have a correlation of 0.99. In other words, big decisions using the ESG ratings may be skewed by the divergence in ESG ratings.
How can the ratings of an individual firm be so different between rating organizations? Here are two important reasons:
Market cap size bias
Within an industry, there can be a large disconnect between an individual company’s ESG rating and the organization’s management & effort related to ESG risks. For example, the waste and refuse management industry, at first glance, would not be considered sustainable. They deal in trash and plastic and how to dispose of it. Your mind probably immediately goes to landfills, plastic floating in water, and exhaust spewing trucks.
But the reality is large waste and refuse management companies like Waste Management and Republic have made significant ESG investments and keep sustainability at the forefront of their work. They are focused on capturing and re-purposing methane from their landfills, running their trucks on recycled fuel, sponsoring zero waste events, and training & educating the public and their employees. Yet despite these notable initiatives, the scores for these companies were in the average range. It seems that industry bias has crept into their ESG ratings.
The perceived Sustainability & Social Responsibility focus of an industry can either boost or deflate an individual organization's rating. Solar energy companies, for example, may benefit from the sector as a whole, while a company in tobacco or pharmaceuticals may have to invest more to overcome an image deficit.
A recent analysis by Earth-Active of 3 top rating agencies** and their ESG scores of the FTSE 100 companies highlights not only the divergence of ESG Raters, but also how certain industries receive higher or lower ratings overall by rating agencies.
In the data above you can see that one of the rating agencies (gray square) appears to rank the entire basic materials sector lower than the other raters, while in the technology sector, they rate companies significantly higher than the other rating agencies. Also looking at these two sectors you can see a second rater (orange circle) rates the Basic Materials sector companies higher, while rating the Tech sector companies lower.
Market-Cap Size Bias
An organization’s size also can help boost their ESG Ratings. The European Commission released a study at the end of 2020 that looked at market-cap and the overall ESG scores across 3 ESG Raters. The results showed that the larger the market-cap the higher the ESG score.
Source: LaBella, Sullivan, Russell, Novikov (EC Study on Sustainability-Related Ratings, Data, and Research)
The skew to larger companies may not be a huge surprise considering they probably have more funds to direct towards ESG initiatives and have dedicated Sustainability & CSR teams within their organization. A large organization’s ability to report on all areas of ESG, even if not material, is more likely and thus resulting in perceived better ESG management by the raters. Conversely, a smaller organization’s ESG efforts should not be rated as less if they are not reporting in all ESG assessment areas or do not have a formal ESG team in place to manage relationships with raters.
While ESG Ratings are useful, they are just one input for evaluating an organization’s Sustainability and CSR efforts. They can be useful (albeit costly) tools to start the ESG Assessment process. However, whether they are being used by an individual company or by investors, ESG ratings need to be used as a component of a more comprehensive ESG Assessment process.
To learn more about Dream Source Solutions’ ESG Assessment Process and the full suite of our ESG Integration Framework: www.dream-sourcing.com email: firstname.lastname@example.org
*The six ratings used in the study were Asset4, Sustainalytics, KLD, RobecoSAM, MSCI, and VigeoEiris
**The companies used in the study were Refinitiv, S&P Global and Sustainalytics