How Material Are ESG Ratings?

How Material Are ESG Ratings?

Blind reliance on companies' environmental, social and governance (ESG) ratings is problematic for investors. Individual companies can receive different scores depending on the ratings provider, while some companies can look better than others simply because they have more resources devoted to reporting.

Materiality is a central concept in ESG analysis, referring to the degree to which a factor can influence corporate financial performance and, by extension, investment returns. On the surface this may seem like a relatively straightforward thing to measure, but as always, reality is more complex – which presents a challenge to anyone attempting to rate companies and portfolios on these grounds.

Indeed, we’re increasingly seeing asset managers question the transparency and methodological differences of ESG data providers – highlighting the risks of relying on only one source. In our view, this is a healthy development, not least because a lack of standardization and clear definitions means companies can score very differently depending on which provider you consult.

 

We may invest in a company that optically may appear less impressive if you take an ESG snapshot versus peers, but that is nonetheless making speedy progress in the right direction

Past ≠ future

Materiality cannot be gauged exclusively through past data. Not only is current ESG disclosure imperfect, but these relationships are dynamic and therefore necessitate a measure of crystal-ball gazing. This imperfection introduces subjectivity into seemingly dispassionate processes. However, as things stand, such assumptions about the future are typically buried underneath the rubric of ‘proprietary research’, which will be closely guarded for obvious reasons.

Current ratings systems are generally biased towards best-in-class businesses, which tend to reward funds with explicit ESG objectives, while penalizing those that take a more nuanced and engagement-oriented approach. What’s more, they may not be sensitive to quality – for instance, that larger companies tend to report more voluminous ESG data simply because they have the resources to do so, and not necessarily because they are the most sustainable.

Big picture

Although we understand the raison d'être behind ESG ratings, we caution against blindly using such yardsticks. Our approach means that we may invest in a company that optically may appear less impressive if you take an ESG snapshot versus peers, but that is nonetheless making speedy progress in the right direction. Through our active ownership efforts, we seek to nudge companies along, highlighting what we consider to be best practice and offering advice as to how they can get there. This does not mean ignoring data and rankings, simply that we try to think more holistically when assessing a company and its long-term prospects.

 

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