How investors can make sense of discrepancies in ESG ratings
As institutional investors grapple with a lack of environmental, social and governance (ESG) standardisations across ratings agencies, gaining familiarity with the attributes that each rating measures and developing in-house research can help to iron out doubts, experts said.
ESG investments – from wind farms in China to social impact initiatives on workers’ rights – are set to reach $50 trillion globally by 2025 from about $35 trillion today.
This has driven a rise in demand – and supply of ESG ratings, scorecards and data by providers such as MSCI, Sustainalytics, FTSE Russell, and Moody’s. However, the US Securities and Exchange Commission (SEC) highlighted potential conflicts of interest as these firms offer an increasing number of ESG-related products and services.
ESG performance has also been inconsistently rated across these agencies. According to a 2019 study by scholars from MIT Sloan and the University of Zurich, the correlation among several major agencies’ ESG ratings was on average 0.61, well below the 0.92 for credit ratings.
INVESTOR CONFUSION
Investors frequently complain that the divergence in standards and practices of ESG rating agencies mean that choosing a credible one, let alone interpreting its rating, is like navigating a maze.
One expert believes there could be an answer to the confusion: investors should focus on the rating that is designed to measure the specific ESG attribute or value, said Yvonne Zhang, risk advisory climate and sustainability leader, at Deloitte Southeast Asia.
“There are a lot of ESG ratings that have different kinds of meanings. The ‘fit for purpose’ is a problem when ratings don't clearly define who is supposed to be benefiting from that particular rating,” she told AsianInvestor.
In some cases, a company may receive multiple contemporaneous ratings from the same agency or multiple agencies may rate the same set of attributes. If that happens, an investor should ask what the nature of each rating is, how is it related to the core business of the company, what impact does it measure, and on which stakeholders, she said.
For example, a waste management company may get a good rating for its social score for building a children’s playground in the community, but this has little to do with its core business and says nothing about what it is doing to prevent water contamination in the same neighbourhood.
EXTRA RESEARCH
Investors should not rely on the ratings but layer them with additional insights from in-house research, said Dan Raghoonundon, ESG research lead at Janus Henderson Investors, though he admits only the larger investment firms may be able to do this.
These efforts include corporate engagements, risk assessments, thematic research, and deep dives into the ESG credentials of individual assets as part of an holistic approach to ESG due diligence.
Edris Boey, head of ESG research at multi-family office Maitri Asset Management, agrees: “We go beyond looking at the ratings - we study the ESG info and data used to determine the ratings, in part because ESG ratings between data providers are known to have low correlation due to their different scoring methodologies,” she told AsianInvestor.
NO GOLDEN RULE
Investors hoping to see a common standard in ESG ratings soon should not hold their breath.
Corporate sustainability best practices can vary greatly depending on each company’s industry context and circumstances, said Boey, adding there is no one-size-fits-all formula to achieving a single perfect standard.
“There is no ‘golden rule’ to determining the balance between E, S, and G issues. As a result, ESG rating agencies deploy different methods to account for these issues - which brings us back to the importance of looking at the weightage of issues,” she said.
Specific national priorities also make harmonisation difficult, said Raghoonundon. “There has been a proliferation of taxonomies globally, with an increasing number of countries adopting their own ESG taxonomies. These reflect domestic conditions, regulatory requirements, and policy objectives and are not entirely comparable across countries, making the standardisation of ESG ratings a challenge,” he said.
However, he believed some standardisation in certain sub-segments is possible. “For instance, climate stress tests could result in the standardisation of the ESG data for banks by specific regions,” he said.
Both Boey and Raghoonundoon agree that a common ESG rating would be a positive development for the investment industry. “A standardisation of ESG ratings would certainly have a more pronounced valuation impact on individual securities, where the premium commanded by ESG leaders versus ESG laggards would become more meaningful,” said Raghoonundon.
Deloitte’s Zhang offers the contrarian view that a standardised rating would not be useful. “ESG is such a wide scope … would one rating system that standardised across the board offer meaningful granularity for decision making?”
In Zhang's view, some divergence in ESG ratings is healthy as it may open new insights for inquiring investors instead of listening to the same assessments.
Movement in Asia
The world may be moving, however slowly, towards a common standard for ESG and in Asia the standard of ESG data disclosure in Asia is also progressing, according to Zhang: “This region’s stance towards ESG disclosure quality and comparability has been very encouraging. Most countries have, since COP26 [the 26th United Nations Climate Change conference in Glasgow in October last year], made progress to be more international.”
For example, Indonesia is introducing a carbon tax that considers corporates' carbon footprint and Scope 3-carbon intensity, despite its opposition to some of the climate action initiatives at COP26.
“Asia has improved leaps and bounds in its approach to ESG, which has translated into better ESG ratings,” said Raghoonundon.
He singled out China, South Korea, and Taiwan for introducing corporate governance reforms in recent years and environmental policies such as plastic recycling that are even more stringent than in the West.