Aggregate Confusion: The Divergence of ESG Ratings

The increase in ESG investing insists businesses reflect a positive corporate social responsibility image. More and more millennials are joining the investment community, which urges companies to act in such a way that appeals to the investors. In fact, investors recognize corporate social responsibility as a more relevant measure of a company’s performance than quarterly earnings. But, measuring the ESG performance is quite challenging. This is the reason why many investors focus more on short-term financial metrics because they have some idea of a company’s profits but don’t know what its ESG performance is.

 


Thus, ESG rating agencies collect and aggregate information on an organization’s ESG performance and come up with an ESG score. However, different agencies disagree on a company’s ESG performance, which results in troublesome divergence in ESG ratings. 

 

Is a High ESG Rating Good?

ESG reports and ratings are an important tool for investors, financial managers, or asset holders that measure a company’s performance against the industry peers. Organizations with a good ESG rating are believed to be better equipped to address potential risks or opportunities and to embrace long-term value creation over short-term profits. Companies with a good ESG score are more resilient over time. Thus, a good ESG rating helps companies attract investors and lower the financing cost.

 

What Do ESG Ratings Measure?

ESG rating is used to assess a company’s exposure to environmental, social, and governance risks. It includes non-financial metrics that measure risks a company has faced. Environmental metrics include risks, like waste management, greenhouse gases emission, energy efficiency, etc. Social metrics measure social/human capital risks, including data security, employee health/safety, product safety, and more! Governance metrics measure risks, like business ethics, transparency, etc.

 

How Are ESG Ratings Calculated?

ESG rating agencies rate organizations based on their ESG policies, systems, or measures and the information they gather from multiple sources, like media, NGOs, publications, or stakeholders. They can also use a questionnaire to collect more information about the company. These agencies use a mechanism to adjust the ESG score of the companies based on the industry. Simultaneously, they also use a company's relative performance against their peers to calculate a universal ESG rating.

 

Correlation of ESG Ratings

As already discussed, interested parties contract with different agencies that give ESG ratings to the firms based on different criteria. However, researchers at MIT Sloan have found that ESG ratings vary tremendously among the agencies. It was found that the correlation among the agencies was on average 0.61. Credit ratings from Standard Ratings & Poor’s and Moody’s are correlated at 0.99. This reflects inconsistent and ambiguous ESG ratings. Such discrepancies in the ESG ratings may lead to real-world consequences.

 

Conclusion

As ESG is calculated with different methodologies, it is bound to diverge. It is tough to believe one agency more than the other when it comes to the ESG ratings. But the silver lining is that ESG ratings’ concept is still in its infant stage. Since it is a central topic for investors, time will tell how successful the improvement attempts will be.


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