Do ESG Ratings Get High Marks?

KEY TAKEAWAYS

  • As interest in ESG investing grows, so too do the ways in which it is measured and reported.
  • ESG ratings providers frequently disagree on company ratings. Because ESG ratings often look at dozens of variables, and because detailed methodologies and score attributions are generally not publicly available, understanding where discrepancies come from can be challenging.
  • Given the subjectivity inherent in ESG ratings, we believe they should be viewed not as objective ratings, but as opinions.
  • Rather than using generic ESG ratings, investors should first identify which specific ESG considerations are most important to them, then choose an investment strategy accordingly.

The volume of sustainability data is growing fast. Greenhouse gas emissions, for example, are now reported or estimated for almost all public companies. This is great news for investors who want to allocate to companies based on their carbon footprints.

Beyond emissions data, the increase in broader company sustainability information can present meaningful challenges. For example, corporate sustainability reports may run a hundred pages long, differ substantially from one company to the next, and may not contain all the information that interests investors. As a result, it is only natural for investors to look for help in deciphering environmental, social, and governance (ESG) data.

THE ESG RATINGS SHORTCUT

At first, ESG ratings may appear a promising tool to navigate this complexity. Providers of ESG ratings may look at hundreds of reported and estimated variables for a single company and boil them down into a single ESG rating. Individual company ratings may then be aggregated into fund and index ratings or scores. Thanks to their convenience, ESG ratings have grown in popularity in recent years.

Globally, regulators have expressed caution. For example, in 2020, then-SEC Chairman Jay Clayton stated that he has “not seen circumstances where combining an analysis of E, S, and G together, across a broad range of companies, for example with a ‘rating’ or ‘score,’ particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise.”

INHERENT SUBJECTIVITY

Beauty is in the eye of the beholder. Often, so too is sustainability. ESG ratings providers frequently disagree on company ratings. The correlation between the ESG scores of different ESG ratings providers has been estimated at 0.54, and even lower when looking at the individual E, S, and G pillars. It is common for a company to be identified as best-in-class by one provider and as just average by another provider. In comparison, the correlation in the credit ratings assigned by Moody’s and S&P is 0.99. These findings are consistent with Dimson, Marsh, and Staunton (2020). Exhibit 1, reproduced from Boffo and Patalano (2020), shows some examples of companies with a high level of disagreement.

Source: Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris, https://www.oecd.org/finance/ESG-Investing-Practices-Progress-Challenges.pdf Note: Sample of public companies selected by largest market capitalization as to represent different industries in the United States. The ESG ratings are transformed using a projection to the scale from 0 to 100, where 0 represents the lowest rating and 100 the highest rating. The issuer credit ratings are transformed using a projection to the scale from 0 to 20, where 0 represents the lowest rating (C/D) and 20 the highest rating (Aaa/AAA). Sources: Refinitiv, Bloomberg, MSCI, Yahoo finance, Moody’s, Fitch, S&P, and OECD calculations.

Disclosure: Values range between -1 (strong negative relationship) and +1 (strong positive relationship). Values at or close to zero imply a weak or no linear relationship. Correlation coefficient values less than +0.8 or greater than -0.8 are not considered significant.

The sources of dispersion across ESG ratings include differences in what is measured, how it is measured, and what weight is assigned to each variable. Because ESG ratings often look at dozens of variables, and because detailed methodologies and score attributions are generally not publicly available, understanding where discrepancies come from can be challenging.

This complexity means that ESG ratings may not be effective at achieving, and sometimes even work against, the sustainability objectives of investors. A recent OECD study found a low correlation between the ESG scores and the E pillar scores of three rating providers. Even less intuitively, it also found a positive correlation between the E pillar scores and carbon emissions for two out of the three providers. In other words, a strong environmental rating was associated with emitting more, not less. Dimensional’s research has also uncovered a statistic that may give environmentally minded investors pause. A key finding in our 2021 study notes that “sustainability” funds vary greatly in reducing exposure to greenhouse gas (GHG) emissions, as one in four US-domiciled “sustainability” branded funds reduce greenhouse gas emissions exposure by only 11% or less compared to the Russell 3000’s emissions exposure.

Overall, given the subjectivity inherent in ESG ratings, we believe they should be viewed not as objective ratings, but as opinions—not unlike the buy/hold/sell opinions that have been issued by sell-side analysts for decades. When using ESG ratings from one provider to allocate assets, investors should be aware that other ratings providers may have dramatically different opinions and ratings.

For example, indices based on ESG ratings may deviate significantly from one another. As of the end of March 2021, the MSCI World SRI Index,1 which emphasizes companies with strong ESG ratings, assigned a weight of more than 12% to Microsoft—nearly four times its market capitalization weight—but excluded Apple and Alphabet. By contrast, in the FTSE Developed ESG Index,2 all three companies were overweighted. It is important that investors understand how these investment decisions are arrived at—but the opacity, complexity, and subjectivity of ESG ratings methodologies may make this understanding difficult to achieve.

FROM ESG DATA TO ROBUST STRATEGIES

Rather than using generic ESG ratings, investors should first identify which specific ESG considerations are most important to them, and then choose an investment strategy accordingly. An example may be reducing exposure to companies with high emissions intensity. The broader the set of objectives, the more difficult it can be to manage the interactions among them. A “kitchen sink” approach that integrates dozens of variables may make it hard for investors to understand a portfolio’s allocations and may lead to unintended outcomes.

Investors should then take a close look at the data. Not all ESG data are created equal, and certain disclosures are more reliable and robust than others. For instance, data that rely on voluntary surveys may inadvertently favor large companies with well-staffed reporting teams, regardless of their actual ESG performance. Equally important is the ability of managers and fiduciaries to deliver meaningful sustainability reporting to their clients. Investment professionals should be confident that the ESG data they use can support the value proposition they seek to deliver to their clients.

This essay also appeared in Wealth Management.


1. MSCI data © MSCI 2021, all rights reserved.
2. FTSE indices © 2021 FTSE International Limited. All rights reserved.


The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value
Dimensional Fund Advisors does not have any bank affiliates.

CANADA: These materials have been prepared by Dimensional Fund Advisors Canada ULC. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and the target market determination (TMD) that has been made for each financial product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to au.dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED OR DIMENSIONAL FUND ADVISORS LTD.
Neither Dimensional Ireland Limited (DIL) nor Dimensional Fund Advisors Ltd. (DFAL), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.

NOTICE TO INVESTORS IN SWITZERLAND: This is an advertising document.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED
Issued by Dimensional Ireland Limited (DIL), with registered office 10 Earlsfort Terrace, Dublin 2, D02 T380, Ireland. DIL is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by DIL to be reliable, and DIL has reasonable grounds to believe that all factual information herein is true as at the date ofthis document.

DIL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DIL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.
Issued by Dimensional Fund Advisors Ltd. (DFAL), 20 Triton Street, Regent’s Place, London, NW1 3BF. DFAL is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by DFAL to be reliable, and DFAL has reasonable grounds to believe that all factual information herein is true as at the date of this document.

DFAL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DFAL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

JAPAN
Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.

Dimensional Japan Ltd.
Director of Kanto Local Finance Bureau (FIBO) No. 2683
Membership: Japan Investment Advisers Association

FOR PROFESSIONAL INVESTORS IN HONG KONG.
This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this material, you should consider whether it is suitable foryour particular circumstances and, if appropriate, seek professional advice.

Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.

SINGAPORE
This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.

This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.  

 

11/12/2021
https://my.dimensional.com/do-esg-ratings-get-high-marks

Dimensional | The Planning Center