ESG Ratings: A Rebuttal of Prevailing Criticisms

“No offence, but…”. This has become a common introduction to questions directed at environment, social and governance (ESG) rating providers and reflects a body of criticism centered on the premise that ESG research and ratings are fundamentally flawed.

Before going any further, it’s worth clarifying that the scrutiny of ESG research and ratings is not only reasonable but is also necessary. Feedback from our clients is critical in driving Sustainalytics’ innovation agenda to ensure that we provide an ESG rating that meaningfully informs investment decisions. However, many good-faith criticisms fail to appropriately characterize ESG ratings, and how this information is ultimately leveraged in the investment process.  

Most critiques of ESG ratings seem to fall under one of the two following themes:

1. Corporate ESG disclosure is inconsistent and lacking. The ratings that are based on that data must also be poor (garbage in, garbage out)
2. Different ESG rating providers offer divergent assessments of the same company, so none can be trusted or used effectively

Argument #1: Bad ESG Disclosure = Bad ESG Ratings

There are undoubtedly issues with the underlying data reported by companies. Different reporting tendencies by region and subjective assumptions can make comparability difficult and brings into question how companies can distort performance – but enough about financial reporting! ESG disclosures from companies also have issues in consistency and comparability, which can make the incorporation of this information into valuation models and investment decision-making a challenging exercise. Specifically, reporting on performance in the social theme (e.g., human rights in the supply chain, community relations) can be limited, and often lacks quantitative metrics.

This argument implies that shortcomings in company ESG disclosure pass through to ESG ratings, limiting the value of such offerings. However, the recognition of imperfect company disclosures demands the application of a robust and transparent research methodology. This is necessary in order to assess the extent to which company policies, programs and performance meet industry best practices, and to contextualize the operational, legal and reputational risks posed by involvement in controversies. The antidote to greenwashing in company disclosures is diligent and thorough analysis from experienced professionals. Specific to Sustainalytics’ approach, there are several components of our research process that are designed to address the issues of limited and inconsistent disclosures.

First, we regularly communicate with the companies we assess, in order to ensure that all relevant information has been captured and to provide an opportunity for feedback. Over the past several years, as the awareness of sustainable investing and Sustainalytics has grown, the company response rate and the quality of dialogue with companies has improved significantly. Second, the Sustainalytics ESG Risk Ratings capture much more than what companies are disclosing. In addition to considering exposure to ESG risk based on sector and company-specific factors, we assess over 60,000 news sources daily for incidents ranging from oil spills to employee discrimination lawsuits. This incident research, and subsequent controversy assessments play a large role in informing our overall view of company ESG risks and the degree to which policies and programs are translating into on-the-ground practices. We are also cognizant that a lack of disclosure on material ESG topics can intrinsically be a signal of weak company management and has been shown to be associated with a higher cost of capital.^[1]

Argument #2: ESG Ratings vary on the same company so none can be used

There are two prevailing reasons why a company’s ESG score may differ between ESG rating firms:

1. They are measuring different things
2. They measure the same thing, but have different views regarding which issues are most material, or which elements of best practice should be considered

ESG rating firms should provide meaningful transparency into their process and be precise about what they intend to measure. If this is not made clear, it is natural that market participants will be dissuaded when, for example, attempting to compare a score that measures the degree of ESG disclosure with an assessment of ESG risk that considers many factors beyond disclosure. Providers of ESG ratings should also offer visibility into the topics they consider by sector and how each indicator is assessed. Why is Business Ethics considered a material issue for Software & Services companies? What specific attributes of a Whistleblower Policy should be present to consider it robust? A black-box approach to producing an overall ESG rating does little to instill confidence in the underlying assessment or allow the flexibility to focus on components of the rating that align with a specific investment view.

Due to a lack of correlation of overall company scores provided by ESG rating firms, many now argue that the only ‘true’ form of ESG integration is an approach that involves the creation of a proprietary ESG score. Firms seeking to differentiate their approach in this way represent an encouraging development, where a simple commitment to ESG integration is no longer an inherent differentiator in the market. However, the reality is that firms have different starting points and philosophies related to ESG integration, which can materialize in diverse approaches. There is a significant body of research that indicates both creating a proprietary ESG score and using direct inputs from a single third-party ESG provider can improve the risk-return profile of a portfolio. For example, the Jantzi Social Index (JSI), which leverages only Sustainalytics ESG Ratings has achieved an annualized return 46bps^[2] greater than the TSX Composite benchmark, since its inception in January 2000.

What is most important, is that ESG factors are systematically accounted for in the investment process, in a manner that aligns with the value proposition and investment style of the firm or product offering. In other words, when you find two different recipes for apple pie, it is completely legitimate to either utilize the elements that you prefer from both to create a new formula, or to simply rely on the recipe from a source you trust, based on the author’s reputation, reviews and transparency provided. The most important thing is to bake the pie.

My hope is that members of the sustainable investment community don’t overlook the role that ESG ratings have had in shaping the industry and avoid broad dismissals of the value of ESG research. Despite good intentions, doing so risks giving credence to the politically charged pushback against responsible investment strategies such as shareholder engagement and ESG integration in pension plans, in addition to potentially confusing and discouraging new entrants. Let’s continue to critically examine ESG data, ratings and integration techniques, but approach such scrutiny in a nuanced and thoughtful way.

^[1] Dan Dhaliwal, Oliver Zhen Li, and Albert Tsang, “Voluntary nonfinancial disclosure and the cost of equity capital: The initiation of corporate social responsibility reporting” (University of Arizona, The Chinese University of Hong Kong, 2010)

^[2] Based on JSI May 2019 total returns