KPIs Skew ESG Scores Due to Materiality Divergence

Investors exposed to “gaps and inconsistencies” by relying on a small number of data providers.

Variations between ESG scores provided by third-party data vendors can be largely attributed to use of different KPIs to measure the financial materiality of ESG risks, according to Calvert Research Institute. Investors who take information from a limited number of data providers “at face value” could be subject to “gaps and inconsistencies”, the institute warned.

For each of 16 ESG risks, Calvert – in collaboration with Sociovestix Labs – created a test portfolio, then applied the relevant KPIs from each vendor to identify their correlation with equity upside, thus isolating the materiality of the indicator to financial performance.

Analysis took factors such as sector, geography and market conditions into account, utilising test portfolios of comparable “peer group” companies.

KPI score performances with a “statistically significant alignment” to financial performance are “indicative of the strength of each indicator’s association with equity upside”, Calvert said.

Divergence between the KPIs and financial performance is a useful indicator to investors that the vendor’s KPI is not providing “decision-useful information related to ESG”.

Investors have long noticed the differences between scores attributed to the same company by different ESG scoring services. Regulators have also noted a lack of transparency and wide differences in methodologies.

The study also suggests that certain KPIs were more reliable indicators of materiality of ESG risks. This includes those relating to ESG risks experienced across a broad range of industries, such as energy use and human capital management.

It found that packaging and electronic waste had the highest proportion of KPIs with strong levels of financial materiality.

Materiality analysis coupled with ESG research by Calvert also revealed which ESG themes with potential upside are “historically under-appreciated by the market” and are therefore strong investment opportunities in the short-term.

“As ESG analysts identify key themes gaining traction across sectors, including climate change and diversity and inclusion, materiality factors signal which themes have already been priced into each sector. Time series analysis of materiality factors to be conducted going forward will help reveal changes in market sentiment towards these issues over time,” the report added.

Calvert noted that third-party KPIs don’t necessarily provide a “valuable materiality signal” over a longer time period. “An ongoing analysis would be required to determine if some KPIs become more of less valuable over time,” the report said.

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