Authors: Henrik Pontzen and Gunnar Friede, both Heads of the DVFA Commission Sustainable Investing
Imagine one analyst rates a security as a buy, while another deems it a sell. Scandalous? Not at all. Isn’t it quite normal that two equally well-trained and recognized experts could reach opposite conclusions after a thorough fundamental analysis of the same company? Then, why do we hear repeated complaints about ESG (environment, social and governance) ratings, deriding them because they too can have differing conclusions?
The demand that rating agencies come to a unanimous judgement when assessing ESG standards arises from false expectations. In terms of complexity, a company’s ESG rating can hardly be seriously compared with a credit rating. The latter evaluates only one facet: what is the probability of default on the coupon and repayment of a bond?
In assessing ESG, both the observation horizon and the number of criteria taken into account are disproportionately greater, and not only quantitative but also qualitative weighting is required. In this respect, a higher spread of results is to be expected per se.
However, the variance is not only due to the complexity of the subject. It also lies in the nature of the subject. For example, the answer to the question of whether electromobility is sustainable may vary depending on the rating agency’s assessment. On the one hand, e-mobility is compatible with the goal of climate neutrality; on the other hand, rare earths are used in the production of batteries, the extraction of which is sometimes questionable from a social and environmental point of view.
The answer to whether a car manufacturer, for example, is a company that operates sustainably can, therefore, be quite different, with good reasons. Which business activities are sustainable and which are not will only be decided in the future. The divergent ratings reflect this openness of decision and give room for different assessments.
Therefore, differing results are not an argument against ESG ratings or against the goal of investing sustainably. Even the fundamental analysis of a company’s stock does not always provide clear results about its actual performance. The fact that different analysts, in good faith and with the best of intentions, arrive at different results – one advises to buy, another to sell – is generally not seen as a sufficient reason to altogether do away with these analyses. ESG ratings should be handled in a similarly relaxed manner, but with a constant desire to conduct better analysis.
Furthermore, the assertion that ESG ratings do not agree to any extent on how to measure a company’s sustainability risk must be questioned. While the argument for a low correlation between individual stocks may be justified, it is not true for the average of companies and ESG rating agencies. This is demonstrated, among others, by a recently conducted study by MIT Sloan. The study’s authors Florian Berg, Julian Koelbel and Roberto Rigobon examine the ESG ratings by leading ratings agencies Asset4, RobecoSam, Sustainalytics and Vigeo Eiris for a universe of more than 800 of the world’s largest companies and found an average paired correlation of 0.7.
E- and S-ratings consistent
The consistency of the ratings is particularly high in the E-areas and for the most part in the S-areas. However, there are larger deviations in the G-areas and when the ratings from KLD/MSCI are added. By way of comparison, the leading bond ratings show a paired correlation of about 0.9 for the MSCI AC World between Moody’s, S&P and Fitch. In other words, the dispersion of the correlation between the providers of ESG ratings is quite acceptable on average, which is all the more surprising as the providers use different rating philosophies and take into account between 38 and 238 indicators in their measurements, i.e. they differ greatly in their methodology in quantitative terms alone. The major providers of bond ratings indeed achieve higher levels of agreement in their ratings. But the correlation in ESG ratings is surprisingly high when considering their complexity.
Assessments of companies according to ESG criteria are already better standardised than their reputation. However, the informed, critical use of multiple ESG ratings and the qualitative, conclusive overall assessment by the analyst remains indispensable for sustainable investing and highlight the strength of the asset manager. Ambiguities and sometimes poor data quality do not fundamentally call into question the concept of sustainable investing. The DVFA Commission on Sustainable Investing sees these findings rather as a mandate to investors to support diversity in rating agencies and at the same time to demand better measurement methods and, in dialogue with the companies, data that is sufficiently reliable and up-to-date.
DVFA Commission Sustainable Investing: https://www.dvfa.de/der-berufsverband/kommissionen/sustainable-investing.html