ESG Ratings - If Only It Was As Easy As "53%"

2/25/21 2:49 PM

When Castle Hall first saw an ESG Rating Report on a public company a few years ago, we were impressed by the precision of the work from the rating provider. The company under review received "53%" for their governance practices (nothing about 'E' or 'S' mind you) as an "average performer" with a "neutral" outlook. Of course, it is now clear that the precision of a 53% rating (definitely not 52% or 54%) is illusory, with different rating firms producing materially different results dependent on their methodology and approach. Which is driving calls for more accountability - and regulation of rating providers.

Earlier this year, the European Securities and Markets Association (ESMA) has called on to the EU Commission to legislate on ESG ratings, joining its voice to those of the Dutch and French financial regulators. In his letter to the European Commission, ESMA’s chair Steven Maijoor emphasized the “need to match the growth in demand for [ESG] products with appropriate regulatory requirements to ensure their quality and reliability.”

ESMA's recommendation comes as investors are struggling with the use of ESG ratings. ESG ratings providers use different proprietary methodologies to assess companies’ sustainability, thus creating confusion for their users. As there is no regulated standard to evaluate the environment, social and governance performance of a firm, there is substantial disagreement between ESG ratings providers. As per MIT Sloan School of Management research, divergence of ESG scores is mainly driven by differences in the measurement of the same indicator and the various scope used by ratings providers. Moreover, investors are concerned by the inaccuracies and the use of old or backwards-looking data to feed ESG scores, according to SustainAbility’s Rate the Raters 2020 report. The same report also highlighted the challenge of condensing all material environmental, social and governance issues into a single "score". (We would actually say that it's pretty much impossible.)

Castle Hall’s own dataset, gathered from our ESG Diligence platform, evidences the struggles asset managers deal with when it comes to ESG Data:

  • 34% of asset managers do not employ at least one ESG service provider
  • 20% of asset managers do not conduct ESG research in-house
  • 20% of asset managers do not review the quality of ESG data used when they do have a service provider

The problem doesn’t stop here. Issues encountered in the development of ESG scores do translate into real-world impacts. According to research published by Scientific Beta, investors relying on average ESG scores to optimize their portfolio will potentially exacerbate estimations errors, replicating the biases underlying those scores. Moreover, “packaged” ratings likely do not help research analysts understand the risks and opportunities behind business practices, thus limiting true price discovery and claims of ESG outperformance.

And companies are aware of these flaws. Tobacco firms, per example, have relied on superior environmental performance or transparent ESG disclosures to boost their score. While again, environmental leadership of such companies is arguable –thinking about released smoke, chemicals and cigarette stubs here - British American Tobacco was included in the Dow Jones Sustainability Indices, which includes the best sustainability performers globally, for the 19th consecutive year in 2020.

Which brings us down to this point: what should ESG ratings providers assess? Is it the responsible business practices of the company, or the sustainability of its business model and its real-world outcomes? Raters that evaluate the broader, systemic impacts of companies will inevitably be led to the challenging question: does this company need to exist?

On the other hand, they also have to answer investors’ expectations. Do their clients simply want a good-looking score (hello virtue signalling), or do they want to truly align their investments with true sustainability objectives? According to KBRA’s CEO Jim Nadler, “investors don’t want ratings agencies or companies to make value judgements, like gun companies are bad. They want us to say this gun company is rated BB.” In other words, some investors might only want to tick the “ESG” box without having to undertake the work that goes behind it, or face the rapidly evolving challenges of building a truly sustainable portfolio. However, it seems that attitudes are changing within the industry. As per Rate the Raters 2020 report, investors’ ESG concerns range from companies’ management of ESG issues to whether the business model is hurtful or beneficial to society.

As we look forward, Castle Hall's ESG Diligence has identified best practices from asset managers in dealing with those ESG scores. When considering the Responsible Investment Strategy of managers subject to due diligence, our diligence suggests that asset managers can source inputs from multiple ESG ratings providers - rather than simply consuming one single "score" for each portfolio company from one source. Then, thoughtful review of the quality of the data provided, building an understanding of the strengths and weaknesses of each providers' model and coverage, creates a deeper understanding of the ESG risks their asset are exposed to. Indeed, understanding the methodology behind the score, and assessing it in relation with their firm’s sustainability objectives, allows for less greenwashing. We have also seen managers only requesting raw data from providers to incorporate into their own scoring methodology. This allows more tailored assessment of the sustainability performance of the companies themselves, avoiding the biases which can be present in the rating providers' ready made calculations.

Only investors and managers that reach this level of detail and understanding of ESG ratings will be able to truly evaluate the ESG profile of current and potential investments. There isn't a simple answer to a complex question - so let's move beyond "this company scores 53%".

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