This article is co-authored by Anthea van Scherpenzeel, Consultant at SustainAbility and Mark Hoff, Partner at ERM and SustainAbility.
In the coming years, financial market participants will rely more on sustainability-related products and services (e.g. ratings, scorings, ESG data, benchmarks, research, etc.) that are offered by a number of specialist and traditional providers (e.g. non-financial rating agencies, data providers, benchmark providers, credit rating agencies, etc.).
As the financial market’s attention to corporate sustainability increases, so do company disclosures of ESG data and the number of ESG rating agencies evaluating their performance.
Correlation between companies’ ratings and rankings by the diverse ESG rating agencies is often low. In this context, one might wonder: Are ESG ratings subjective and not comparable?
Potential reasons for variation in sustainability performance
Several generic problems related to data and methods of ESG ratings might lead to a low correlation between companies’ ratings and inadequacies when comparing companies’ rankings within a sector. These might include, but are not limited to:
Lack of methodology standardization: In essence, an ESG rating is a sector-relative score assigned to an individual entity according to its performance against a weighted set of sustainability indicators. The methods — and how to measure and weight particular ESG factors — have been developed by each individual ESG rating agency, influenced by their individual views on the relative significance of these factors and whether good performance of one factor can compensate for the poor performance of another factor. The lack of a common methodology might lead to little comparability of ESG ratings and rankings and thus might misrepresent companies’ ESG commitment if limited sources are utilized for decision-making processes by financial market players.
Possible structural bias in ratings assessments: The largest cause of bias appears to be that ESG ratings depend fundamentally on disclosure. This is inclined to favor:
- Large companies that tend report on ESG factors in greater proportion and have the financial resources to pay specialist consultants to complete questionnaires;
- English-speaking companies, as much research is undertaken by English-speaking analysts;
- European-domiciled companies who are more aware of the size and influence of sustainable investment.
Bias in ratings assessments leads to a lack of impartiality that can distort a company’s true ESG performance.
Data acquisition and data processing: To acquire a company’s data, rating agencies use different processes including companies’ sustainability reports, surveys sent directly to companies, engagement with companies (e.g. through meetings, interviews or workshops) and other sources of information. In order to deal with unreported data or data inconsistencies, ESG rating agencies often use in-house statistical models to create estimates based on market averages and trends. The diverse data collection processes as well as different estimation models for unreported or inconsistent data create further divergence in ESG rating and rankings.
EU sustainability ratings and research study to identify and address current issues
The European Commission’s Directorate-General for Financial Stability, Financial Services and Capital Markets (DG-FISMA) has appointed SustainAbility, an ERM Group company, in collaboration with Hindsight Consultancy, Institutional Investor Research, Minter Ellison and SRI-CONNECT, to undertake a comprehensive study to enhance the understanding of the low correlation between results of assessments of the same company done by different providers. At the same time, the study will investigate if a low correlation is regarded as a strength or a weakness in the ratings landscape.
In this respect, the study will explore issues related to:
- The processes providers go through to ensure the accuracy of the data they collect and/or estimate, and the procedures for dealing with any data inconsistency
- The data assessment processes carried out by providers
- The transparency of the methodology of ESG ratings used to measure the sustainability of companies and other issuers.
In order to address these issues, we would appreciate your input. We invite companies, providers of sustainability-related products and services and other actors in the sustainable finance sector to participate in this initiative through the online survey or to contact us to be further involved.
To participate in the online-survey: https://www.sri-research.com/ec-study-known-knowns
For more information, please contact: SustainabilityRatings@ERM.com
A message from the European Commission:
“The European Union is strongly supporting the transition to a low-carbon, more resource-efficient and sustainable economy. As part of the action plan on sustainable finance, the European Commission’s Directorate-General for Financial Stability, Financial Services and Capital Markets (DG-FISMA) has appointed SustainAbility, an ERM Group company, in collaboration with Hindsight Consultancy, Institutional Investor Research, Minter Ellison and SRI-CONNECT, to conduct a comprehensive study on Sustainability Ratings and Research. The results will feed into the work to implement the Commission’s sustainable finance action plan.”