Previous story:

Daddy Jones Bar & Restaurant introduces the Coffee Shop; Available on Saturdays and Sundays to take away or on the terrace

CUHK Business School Research finds inconsistent ESG values ​​from various rating agencies

Published on September 24, 2021

HONG KONG SAR: Sustainable investing, which was considered an outlier maybe just a decade ago, has never been more popular. To put things in perspective, US sustainable funds saw record investments of nearly $ 2 trillion in the first quarter of 2021, according to industry data provider Morningstar. As the demand for environmental, social and governance (ESG) investments grows, so does the need for higher quality ESG performance data. However, a recent research study found that ESG ratings of companies provided by various agencies can be confusing for investors and may prevent the sustainable investment sector from reaching its full potential.

It is not uncommon for the ratings of different ESG rating providers to be very different. For example, Tesla Inc. is rated average by MSCI ESG ratings, but rated as high risk by Sustainalytics. (Source: iStock)

Sustainable investing, also known as ESG investing or socially responsible investing, is an approach that requires investors to consider a company’s ESG profile in addition to financial metrics when making an investment decision. These additional factors include everything from a company’s energy use, waste, and pollution to its working conditions, participation in its community, and diversity on the board. Given these considerations, it is not uncommon for sustainability-minded investors to set maximum limits or even shy away from less “ethical” sectors such as coal, defense, gambling or tobacco.

Perhaps due to its relatively recent arrival in the financial world – the term ESG investing itself was first coined by the UN Global Compact as part of a pioneering study entitled Who Cares Wins from 2004, there is neither a universal standard nor a generally accepted method to calculate ESG ratings between different agencies. According to KPMG, there will be around 30 major ESG data providers worldwide in 2020. These rating agencies typically use different metrics when creating their ESG scores. It’s not uncommon for them to give different ESG ratings for the same company. For example, Tesla Inc. is rated average by MSCI ESG ratings, but rated as high risk by Sustainalytics.

The new study Sustainable Investing with ESG Rating Uncertainty was jointly carried out by Si Cheng, Assistant Professor in the Department of Finance at the Business School of the Chinese University of Hong Kong (CUHK), Prof. Doron Avramov from IDC Herzliya, Prof. Abraham Lioui at EDHEC Business School and Prof. Andrea Tarelli at the Catholic University of Milan.

In their study, Prof. Cheng and her co-authors tested their hypothesis on US stocks from 2002 to 2019 and examined the ratings of six major ESG rating providers – Asset4 (Refinitive), MSCI KLD, MSCI IVA, Bloomberg, Sustainalytics and RobecoSAM . In line with existing studies on ESG ratings, the research team also found significant differences between different ESG rating providers. They found that the confusion among different ratings by ESG rating agencies made sustainable investing riskier and reduced investor demand for stocks.

Disagreements

“In general, there is a lot of ESG data on companies because there is no consensus on how to report, measure, and interpret ESG information, and it can be both overwhelming and confusing. As a result, it can be difficult for investors to figure out the “true color” of a company, be it green, brown, or something in between, ”says Prof. Cheng. “This, in turn, is fueling investors’ appetite for sustainable investments. Of course, if an investor is looking for ESG games and is unsure of the sustainability of the stock they are looking to invest money in, they will think twice before proceeding. ”

Using data from the six ESG rating providers, the researchers generated an ESG score for each stock, as well as a score to measure the difference in ESG scores between the six agencies to calculate the level of uncertainty in ESG ratings. According to the results, the average rating correlation is only 0.48 and the average ESG rating uncertainty is 0.18. In perspective, this means that a company could be classified in the lower third by one data provider, but in the 59th percentile by another.

Using these ratings, the researchers examined how the inconsistency in ESG ratings affected whether an institutional owner would invest in a particular stock and how the stock’s actual performance in the marketplace. The study considered three different types of investors. The first type are organizations such as pension funds as well as university and foundation foundations which, compared to other institutional investors who are more interested in generating financial returns, limit their investments to socially acceptable standards (e.g. through socially responsible investing). like hedge funds.

The study found that institutions more constrained by investment norms, while advocating greener companies, were less likely to hold green stocks when ESG ratings were very conflicting. In companies with the highest ESG scores, institutions with restricted standards hold an average of 22.8 percent of their shares, but only if the ratings of the various ESG agencies are very similar. When the correlation of ESG ratings between the different rating agencies was low, the proportion of institutional owners dropped to 18.1 percent.

In contrast, hedge funds invest more in brown stocks on average, and rating uncertainty primarily affects their holdings of brown stocks. For companies with the lowest ESG scores in the study, the researchers found that, on average, hedge funds owned 15.7 percent of the stocks when the ESG scores of different rating agencies were closely matched. This fell again to 13 percent when the correlation in the ratings of various agencies diverged. The authors conclude that rating uncertainty is most important for investors in their preferred investment universe.

And while companies focused on improving their ESG performance are expected to achieve lower investment returns because of providing intangible benefits to investors, the study found that this has not always been the case. In particular, it turned out that brown stocks only outperform green stocks when the ambivalence of the ESG ratings is low. With a high level of correspondence between the ratings of various ESG rating agencies, brown stocks outperform green stocks by 0.59 percent per month for absolute returns and by 0.40 percent per month for risk-adjusted returns. However, as the inconsistency between ESG ratings increases, there is no clear link between a company’s ESG bias and its stock performance.

Effects on the market

Finally, the study implies that the ambiguity in ESG ratings affects the overall stock market as a whole. In particular, higher levels of rating confusion are associated with higher market premiums as well as lower equity market participation and lower economic prosperity for ESG-sensitive investors.

Green stocks are hurt the most when there is a lot of confusion about ESG ratings. Companies that adopt a more responsible approach in their business will be penalized disproportionately if rating agencies fail to agree on their ESG profile. This, in turn, would further limit their ability to invest capital and create real social impact.

“Given the uncertainty about a company’s ESG profile, ESG-sensitive investors are just as likely to stop making ESG investments or engage in ESG corporate matters,” added Prof. Cheng.

Overall, the study results have a significant impact on asset allocation, investor welfare, and asset pricing. To minimize the disadvantages of investing in ESG due to the inconsistent ratings, Prof. Cheng and her co-authors suggest that companies publish more open reports on their ESG performance. ESG rating providers advise researchers to further publish and explain their rating practices and methodologies. In addition, they argue that more public discussion on how to measure the ESG performance of companies should help improve the quality of ESG ratings.

“Sustainable investing is on the rise. Therefore, the overall impact of the ESG rating inconsistency becomes even clearer, ”says Prof. Cheng.