Rating the Unknown                                                    Boom in ESG score, but data show little correlation

According to Morningstar, around 2.7 Trillion Dollars are now invested in more than 2900 ESG funds, an increase of 57% from 2020. Yet giving a clear definition of an ESG fund is no easy deal: ESG, now the hottest acronym in finance,  stands for Environmental, Social and Governance. So, ideally, by putting your money in such a fund you are rewarding those companies more committed to a sustainable future.

Moreover, the argument goes, in the next future regulations on ESG matters will become stricter, therefore by investing in firms ahead of this you are hedging against the risk of fees and lower future returns caused by changes in strategies (from the supply chain to production to the relationship with customers) necessary to comply with new laws and regulations. 

Now, this seems cool right? Higher expected returns, lower volatility and you are also doing something good for the environment and the community. Wow. 

But a question arises: How can you estimate the ESG performance of a company?

Well, as you would do with a stock or a bond, you are likely to look at the rating. There are plenty of providers, the most famous being MSCI, Morningstar’s Sustainalytics, and FTSE Russel. There are also the AI driven Refinitiv solutions and Clarity AI. 

You may presume that the ratings do not differ too much between one agency and the other, i.e. if a company is considered sustainable by MSCI it is pretty much the same for S&P. At least, this is what happens with bonds and stocks.

Yet empirical evidence shows that it is rarely the case.

In “Divergent ESG Ratings”, an article recently published by Elroy Dimson, Paul Marsch and Mike Staunton in the Journal of Portfolio Management, the three scholars show that there is little correlation between one provider and the other. The authors analyzed data on U.S. large companies, showing  the overall rating by different agencies in a chart, in a scale going from 0 to 100. Wells Fargo, active in the financial services sector, obtains an overall score of around 12 according to MSCI, exceeds 60 for Sustainalytics and approaches 100 for FTSE. A similar pattern characterizes Walmart: overall ESG score of 20 for MSCI, 70 for Sustaynalitics and around 95 for FTSE. I see some variance there. 

It is now clear how problematic taking decisions becomes for a portfolio manager or  a retail investor willing to invest in ESG driven companies. The main reason behind this variance lies in the parameters used by agencies in their valuations. There is a wide array of disparate issues that are not easily compared. It is somehow similar to what happens with  university rankings.

 Each provider uses different parameters in order to assess the value of the institution, with some giving more importance to academic research and faculty/students ratio, while others focusing more on employability or the presence of  international students. 

Conversely, when an agency evaluates a bond it has more definite parameters, as ultimately the potential investor is interested in knowing the likelihood of receiving coupons and the principal at the end of the term. So it goes for stocks: a rational investor wants to know whether in the medium or long term a given stock price will increase or not. 

The one word we have now to focus on is standardization:  in the ESG objectives as well as in the reporting methods. Particularly fascinating is the reporting side of this discussion. So far the European Commission has tightened the “Non financial reporting directive”, previously applicable only  to large public interest companies; it also  passed the “Sustainable Finance Disclosure Regulation”, aimed at making the ESG score of funds more easily comparable, with the implementation of standardized metrics, and the Taxonomy. It is a precise list of environmentally sustainable economic activities that also defines technical screening criteria for each environmental objective. 

Finally the IASB, the International Accounting Standards Board has been improving the IFRS (International Financial reporting standards) to include standardized ESG metrics in the reports. The relevance of this project lies in the fact that the IFRS is used by companies in over 120 countries, and this would represent a big step ahead in the standardization process also in countries less inclined toward sustainability. 

In conclusion, ESG scores and ratings are not the solution, but the starting point. They have to be supported by scrutiny and holistic understanding of the strategy of the company to ensure that it reflects the values of the end-investor.