A growing number of investors are dipping their toes into sustainable investing and have started to include environmental, social and governance (ESG) criteria in their investment mandates. Their selection of securities often involves a combination of third-party ESG ratings and due diligence analysis. However, with the growing popularity of ESG investing there has been growing scrutiny – and, indeed, some criticism – of the transparency of ESG ratings.

ESG-related investments certainly are popular and set to grow. A total of 3,826 signatories, as of March 2021, representing over US$121 trillion of assets under management have signed a commitment to incorporate ESG issues into their investment analysis and decision-making processes, according to the United Nations-backed Principles for Responsible Investment (PRI) initiative. The sheer size of this market has led to development of an array of off-the-shelf ESG rating products that provide quick and easy insight into the sustainability performance of investment portfolios.

The importance of ESG ratings and third-party data products in the ecosystem are highlighted by the International Organization of Securities Commissions, which states that they are critical when consistent and comparable issuer disclosures are unavailable.  As well, the organization notes: “Their significance and usefulness will only continue as capital markets intensify efforts to support the shift towards a net-zero economy.”

However, recent research from MIT’s Sloan School of Management and the University of Zurich shows that most ESG ratings have presented substantial discrepancies and demonstrated a weak correlation. It further suggests that the divergences stem from the different sets of attributes, raw data and views on the relative importance of the attributes. This misalignment could lead to underinvestment in ESG improvement activities ex-ante and challenges in evaluating ESG performance. The research also suggests that the misalignment undermines companies’ incentives to improve ESG performance, disperses the effect of that performance on asset prices, and brings uncertainty into the decision-making process.

The mixed message from the inconsistent ESG ratings has propelled portfolio managers to take the helm and make the call themselves. “We take [ESG] data feeds from trusted third parties,” says Bill Davis, founder of Stance Capital, a US-based asset management firm. “What we do is gather [ESG] data from issue-specific entities and use that data to apply score deductions before giving the companies a final score.”

Certain large ESG rating bodies, Davis notes, fail to provide sufficient disclosure in the breakdown scores. “You do not necessarily know how they derive the scores. For example, many US ESG investors are concerned about climate risk and do not want to invest in fossil fuel companies. But they might be surprised to know that MSCI has recently ranked Exxon Mobil very high [ESG-wise].”

He adds: “It is incumbent upon portfolio managers to understand what kind of portfolio they are trying to build around” and the value set it is targeting, for example, greater scrutiny of data to avoid greenwashing.

The main ESG data challenges faced by institutional investors that present impediments to integration, according to BNP Paribas’s ESG Global Survey 2021, are inconsistent data across asset classes, data quality and consistency, conflicting ESG ratings, and ineffective data for scenario analysis.

A consultation paper on a proposed regulatory framework for ESG rating providers and oversight of disclosure released in January by the Securities and Exchange Board of India cites as major integration impediments a lack of Indian-specific rating agencies, and insufficient transparency in the methodology and use of ratings by investors.

Another report, published by the European Securities and Markets Authority in June, highlights as integration headwinds the lack of comparable and standardized ESG data, a misalignment in the definition of ESG, and a lack of coverage for small and medium-sized enterprises (SMEs) and non-listed companies. The report also notes the increasing market concentration of US-based ESG rating providers, whose methodologies are “consistently biased towards larger and/or listed companies, and US industries”. 

Regardless of any bias, the standardization of ESG criteria is still challenging as its design involves subjective judgement. The social and governance parameters of ESG may not be as standardized as the environmental aspect, says Haider Mannan, founder of UK-based data provider BigTXN. “Violations are usually standardized. You can easily capture what is bad,” he says. “But there is no norm and global standard for doing good.”

Aside from quantifiable hard data, soft data also plays a critical role in providing insights into ESG assessments. Peer review among institutional investors, for example, is of great use, particularly when negative screening is one of the dominant approaches to ESG investing.

Currently, there are about 7,000 companies worldwide being divested or excluded from ESG investment under negative screening, and the list is updated every day, Mannan says. The views of institutional investors on the ESG performance of companies are sometimes shared with each other. The data provider adds: “It's a community effect that they are looking to create; and, through this utility, we have this idea of a community database.”