RepRisk: it’s time to bid ESG ratings farewell

31 May, 2021 02:03
source: Singularity Financial

Singularity Financial Hong Kong May 31, 2021 –  Alexandra Mihailescu Cichon, executive vice president at RepRisk, an ESG data science firm, says it’s time to bid ESG ratings farewell.

ESG ratings are an oversimplification

Over the years, numerous rating agencies have created ESG ratings based on company self-disclosures, which can often result in potentially biased, incomplete, and unreliable findings. Self-reported data is opaquely one-dimensional and often does not account for ESG risks that have bottom-line compliance, financial, and reputational impacts for companies. The methodologies that ESG rating agencies use can be thought of as “black-box methodologies” because there is so little transparency and no way to compare data.

Alexandra pointed out that, the information that decision-makers received was “relatively noisy” and contributed to “aggregate confusion.”

It’s hard to overstate this lack of consistency and clarity and the importance of transparency and reliability in ESG data. A well-known and now oft-cited study by MIT’s Sloan School of Management compared the ratings of five prominent ESG ratings agencies. 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.

Further, companies and investors often feel like meeting ESG standards is a constantly moving target. While there is a broad-based effort underway to develop a universally accepted set of global sustainability reporting standards, the process is expected to be lengthy, complex, and arduous.

Going beyond ESG ratings

Alexandra points out in recent article, “using publicly available sources and stakeholder information to identify and assess material ESG risks built on a rules-based and transparent methodology can deliver reliable, comparable, and actionable data. It provides investors with a clear use case and track record to inform business and investment decisions.”

Investors and companies do not have the option of waiting for clarity.

“As companies increasingly pivot their business models to integrate ESG factors and as the risks from ESG issues such as climate change mount, the need for robust and reliable data will only grow. Just as considering ESG factors was at one time revolutionary, it is time for the next chapter in the evolution of ESG, one that goes beyond the current ESG ratings paradigm”, Alexandra added.

“The necessity of this approach is underscored by research that shows risk-based approaches to not only reduce risks and volatility, but to generate alpha and deliver outperformance.”

ESG controversies can be especially costly and longlived

Savita Subramanian, the head of Global ESG Research within BofA Securities, gave her input during recent discussion with RepRisk, ” ESG controversies can be especially costly and longlived, and even highly regarded companies are subject to such reputational risk.”

In fact, she estimate more than $600bn of market cap for S&P 500 companies has been lost to ESG controversies, such as data privacy issues or governance failures, in the last seven years alone. And controversies are a long-lived overhang — “the average stock doesn’t recover from a controversy until almost a year has passed, based on our analysis of recent controversies for S&P 500 companies. So, we think investors of all stripes — not just ESG-focused investors — can use ESG controversy data to better manage risk.”

One of the challenges that investors face is that many traditional ESG ratings providers use company reports and other self-disclosed sources, which often do not capture daily-updated ESG controversy data. “We think integrating daily-updated ESG controversy data from third-party sources can augment company-disclosed data and signal emerging ESG risks so that investors can quickly assess and respond”.

One challenge in analyzing companies from an ESG lens within small caps is the consistently lower disclosure by these companies – they are earlier in their life-cycle and
may be resource-constrained relative to their large, mature counterparts. To bridge the disclosure gaps, alternative ESG data providers that draw on other sources besides company disclosed data can be really useful in assessing ESG risks for smaller companies.

Also the “good” companies that are highly rated on ESG or highly owned by ESG funds face emerging ESG controversies. “We found that…those with high ESG scores as measured by Sustainalytics — tended to underperform even more than the average stock when controversy ranks jumped (i.e. risk increased).

So investors are increasingly leveraging company-disclosed ESG data alongside daily-updated ESG controversy data sets to better assess current and emerging ESG risks.