Are inconsistent ESG ratings downplaying the companies truly committed to sustainability?
The Institute for Energy Economics and Financial Analysis (IEEFA) shows that greening and transition efforts are at risk of being underrated in their "Greater ESG rating consistency could encourage sustainable investment" report.
They highlight some of the main results of their study before formulating recommendations for market participants:
- Lack of consensus among ESG raters leads to stock-picking inaccuracies and errors in stocks and bonds pricing.
- Inconsistent ESG rating practices amongst rating providers prevent proper assessment of a company's impact on society and the planet by asset managers.
- Companies transitioning or already contributing to a low-carbon economy can have their positive impact downplayed.
- The best-in-industry approach focuses on sector-specific risk exposure and lowers the importance of actual company-specific performance.
- Raters show major biases due to companies' sizes and geography, with big companies in countries with high disclosure requirements getting better results.
- Raters and investors need to be clear about the trade-off between financial returns and extra-financial impact their methodologies strive to achieve.
- The authors recommend working on standardised and transparent frameworks for rating methodology and disclosure over time. They also support regulatory intervention in the ESG rating sector to enforce them.
The very idea of making financial decisions based on a single aggregated ESG score may not be appropriate, as E, S, and G scores as well as other sub-factors could better support specific investment theses.
ESG ratings today do not work as intended and therefore hardly allow for more "responsible" investment. Significant measures by both practitioners and regulators are required to refocus on this goal.