Investors must beware of pitfalls posed by ESG ratings

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The use of environmental, social and governance (ESG) ratings has increased sharply in recent years and entered the mainstream investment arena. Such scores and ratings now constitute an important element of security, fund and mandate selection, which has led to strong growth in the number of ESG rating and data providers. However, ESG ratings present several challenges that asset owners and managers should be aware of when assessing the sustainability of securities, funds and mandates.

NN Investment Partners (NN IP) recognises that ESG scores have come a long way, with quality gradually evolving towards more material and behaviour-based scores and away from the more traditional policy-based scores. Still, investors should remain cautious when using external ESG ratings. "Pitfalls remain, sometimes resulting in counter-intuitive outcomes. However, these pitfalls can be overcome if they are addressed in the right way.

NN IP has identified five common pitfalls investors face when using external ESG rating agencies:  

Size biases can favour larger firms
ESG ratings often display a size bias that gives larger firms better ESG scores on average. This does not necessarily mean that larger companies take better care of the environment or society. More often it is the result of larger companies having more resources to develop and report on their ESG policies and activities.

Sector neutrality can lead to counter-intuitive results
Most ESG scoring methodologies include  a type of sector neutrality. This means that every sector includes the full range of ESG scores. Even in sectors with serious sustainability issues  - such as oil  and gas -  some companies will score highly on ESG metrics. This could lead to a clear conflict with sustainability. Companies active in sectors that are arguably inherently unsustainable, such as tobacco and traditional energy, can still obtain high, above-market-average ESG scores driven by their policies

Correlation is low between ESG rating agencies
The correlation between ESG scores from different data providers is often limited. Research from CSRHub shows that the correlation between ESG scores from different rating agencies can be as low as 0.3, indicating a clear lack of consistency. A recent study from the Massachusetts Institute of Technology (MIT) also highlighted this discrepancy. This illustrates the subjective nature of ESG scores, which is partly due to the different methodologies applied. The insights and arguments underlying scores can still be valuable, but it is also possible for a single security to have a wide range of ratings

Ratings become stale over time
ESG scores from the traditional rating agencies can become stale. A company's ESG score today is often comparable to its score from three years ago. This can be partly the result of infrequent review cycles and the fact that specific ESG data points do not tend to change much. Yet, there is a risk that changes in underlying ESG trends might take some time to show up in ESG ratings. Thus, new ESG rating agencies are emerging that, by using new technologies, focus more on timely, news flow-driven ESG data, leading to more frequent updates.

Reporting standards are still mostly absent
Collecting high-quality, comprehensive data remains a challenge. A key reason for this is that companies are not required to report on most types of ESG data. Although companies may well volunteer ESG information, this often lacks consistency because regulators do not stipulate standards to the same degree that they demand in financial data, for example.

Jeroen Bos added: "ESG ratings are opinions, not facts, so it is crucial to understand the viewpoints behind them. ESG scores might produce a diversity of outcomes with low correlations but combining different ESG sources with in-house analysis only enriches insights and improves the decision-making process."

NN IP has identified further opportunities for investors to avoid these pitfalls. By focusing on material ESG aspects - i.e., aspects with an impact on a company's long-term ability to generate cash flow and hence its long-term share price - investors can ensure good alignment between ESG integration and improving risk-adjusted returns. As research shows that companies with improving ESG credentials demonstrate better risk-adjusted returns, it is also important to focus on a company's behaviour and momentum towards improvement, rather than its stated policies. Moreover, asset managers and owners can significantly aid improvement in ESG data by engaging with corporates. Finally, the use of new technologies such as natural language processing and machine learning could further improve ESG insights by improving the completeness, timeliness and quality of data sets.

Jeroen Bos is head of Specialised Equity & Responsible Investing, NN Investment Partners