ESG Ratings Diverge Substantially, with Real-Economy Impact

Analysis across six key ratings agencies finds significant differences in how indicators are measured.

ESG ratings from different providers disagree substantially, and much more than those of credit ratings agencies, according to a study published in the Review of Finance, the journal of the European Finance Association.

The study, by researchers from MIT Sloan and the University of Zurich, looked at ESG ratings from KLD, Sustainalytics, Moody’s ESG, S&P Global, Refinitiv and MSCI.

The divergence could be having a tangible effect on the real economy’s transition to a more sustainable future, given the potential impact of ratings on asset prices and corporate behaviour, the report said.

“Theory predicts that investor preferences for ESG affect asset prices. In practice, however, investment choices are guided by ESG ratings, making the construction of and disagreement among ESG ratings a central concern,” the study said.

Regulators are increasingly focused on sustainable-investing ratings in a bid to deter greenwashing. Just this month, the UK’s finance ministry said it is considering whether to regulate ESG raters, while the US Securities and Exchange Commission proposed rule changes to prevent misleading ESG claims by funds.

Last November, the International Organization of Securities Commissions published a set of recommendations for securities regulators to consider in their oversight of ESG ratings and data-product providers.

“ESG rating divergence does not imply that measuring ESG performance is a futile exercise,” the study said, pointing to the benefits of regulators harmonising ESG disclosure as a way to help provide a foundation of reliable data.

“However, it highlights that measuring ESG performance is challenging, that attention to the underlying data is essential, and that the use of ESG ratings and metrics must be carefully considered.”

Growing demand for ratings

ESG ratings first emerged in the 1980s as a way for investors to screen companies, and the market for ratings has grown in tandem with a growing appetite for sustainable investing. Many early providers went on to be bought by established companies, with MSCI acquiring KLD in 2010 and Morningstar taking a 40% stake in Sustainalytics in 2017.

Credit ratings tend to diverge less than their ESG counterparts because creditworthiness can be more clearly defined and financial reporting standards are more mature, the study said. In contrast, ESG ratings agencies in effect offer an interpretation of what ESG performance means, amid competing reporting standards for disclosure, many of which are voluntary.

The divergence makes it difficult to evaluate the ESG performance of companies, funds and portfolios, decreases companies’ incentives to improve their ESG performance, and introduces uncertainty into any decision taken based on ESG ratings, the researchers said.

“Companies receive mixed signals from rating agencies about which actions are expected and will be valued by the market,” said the report, potentially leading to underinvestment in ESG improvement activities.

The study looked at three main reasons for the divergence: scope (for instance, one agency may include lobbying activities while another may not), measurement (labour practices, for example, could be measured by workforce turnover or by the number of labour-related court cases taken against the firm), and weight (for instance, placing greater weight on labour concerns than on lobbying).

The study found that of the three, measurement is the key factor in the differences in ratings between agencies, contributing 56% of the divergence. Scope accounts for 38% and weight 6%.

In particular, a measurement ‘halo effect’ was found to drive 15% of the overall divergence, meaning a firm receiving a high score in one category is more likely to receive high scores in other categories, as the agency’s overall view of the company informs the results.

With ESG ratings and metrics forming an important foundation for the field of sustainable finance, the divergence begs the question of how uncertainty in ESG ratings affects asset prices, the study said.

“Our results raise the question of how companies respond to being scored differently by different raters, which will inform the effects of sustainable finance on the real economy.”

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