New research from MIT shows a poor correlation between ESG scores from ratings providers.
A new paper from the Massachusetts Institute of Technology (MIT) – Sloan School of Management says that the divergence between ESG scores from ratings providers continues to be a problem in the investment industry creating “an impediment to prudent decision-making that would contribute to an environmentally sustainable and socially just economy.” The paper, “Aggregate Confusion: The Divergence of ESG Ratings,” looks at divergence between five ratings agencies; KLD, Sustainalytics, Video-Eiris, Asset4, and RobecoSAM. The research found the correlation among those agencies’ ESG ratings was on average 0.61; by comparison, credit ratings from Moody’s and Standard & Poor’s are correlated at 0.99. The paper states that a lack of consensus around ESG ratings for specific companies can lead to:
- Corporate stock and bond prices that are unlikely to properly reflect ESG performance as investors struggle to accurately identify out-performers and laggards
- A dampening of ambition of companies seeking to improve their ESG performance, due to the mixed signals they receive from ratings agencies about which actions are expected and will be valued by the market
The main reason that ratings differ is simply because of the different definitions used by agencies in scoring individual company’s ESG performance. The paper identifies three distinct sources of divergence:
- Scope divergence can occur when one agency includes greenhouse gas emissions, employee turnover, human rights, and corporate lobbying in its ratings scope, while another doesn’t consider lobbying
- Weight divergence can happen when agencies assign varying degrees of importance to attributes, valuing human rights more than lobbying, for example
- Measurement divergence occurs when ratings agencies measure the same attribute using different indicators. One might evaluate a firm’s labor practices on the basis of workforce turnover, while another counts the number of labor cases against the firm. While both capture aspects of a firm’s labor practices, they are likely to lead to different assessments, the research cautions
All told, the research team was able to determine that differences in measurement explained 50.1% of total differences among ESG ratings, with divergence in weight explaining 13.2% of differences, and divergence in scope accountable for an average of 36.7% of differences. Taken together, weight and scope divergence can be seen as how a given rating agency defines sustainability. In addition, the team also identified a “rater effect” — when the ratings agencies’ assessment of a company in individual categories seemed to influence their views of the company as a whole. Specifically, when a rater judged a company as positive for a particular indicator — human rights, say, or labor practices — they were then more likely to judge other indicators as positive too.
What can companies do about this diveregnce in ratings?
According to MIT, companies should work with individual ratings agencies to establish open and transparent disclosure standards and ensure that data is publicly accessible, moves that will discourage agencies from basing their ratings on sources prone to divergence. According to the paper, one of the reasons why you have this divergence is that ratings agencies will try to find proxies if they don’t have access to data, which can lead to inaccuracies and divergence. Investors can also use the researchers’ methodology as a framework to disaggregate ratings and impose their own weighting on indicators, hopefully leading to the development of a more coherent decision-making process. In the short term, Berg said, companies should conduct a thorough due diligence before choosing one rating agency over another.