We have updated our Terms of Use.
Please read our new Privacy Statement before continuing.

ABCs of ESG

10 August 2018 By Shiva Rajgopal and Richard Foster

Socially responsible investing has become a $20 trillion-plus industry. From universities to municipalities, sovereign wealth funds to pension funds, and Generation X to millennials, investors and shareholders alike are flocking to stocks with high environmental, social and governance (ESG) scores.

Monthly investment flows into sustainable funds averaged $924 million over the first five months of the year, nearly twice the 2017 average, according to Morningstar. Fortune 500 companies are also spending billions on corporate social-responsibility programs per year. The rise of socially responsible investing shows an eagerness to back companies that are seen to be upright corporate citizens delivering societal benefits. But it also raises an important question. Mainly, how do we know if firms are actually doing well by doing good?

Investors rarely have the expertise or the resources to invest in measuring the ESG attributes of a company. Therefore, they and most of their fund managers rely on commercial intermediaries to supply information about ESG ratings, such as MSCI and ASSET4. The problem is, measuring the environmental (the “E”) and social impact (the “S”) of a firm is extremely difficult. It’s also complicated to measure corporate governance (the “G”) because outsiders can only observe the composition of the board, but not what the board actually does. So what data do these agencies use in their analysis and how do they arrive at a rating?

We took a closer look at the components that make up these ratings. Overall, we were disappointed by the lack of transparency and rigor of ESG ratings. In particular, we found four big problems:

Methodology

The processes the agencies use to gather and analyze the data that ultimately translate into a rating are confusing and inconsistent. Unlike ESG-rating agencies, credit-rating agencies, such as Moody’s and S&P, are relatively more transparent. They provide the input variables, for instance, that they use to compute a firm’s debt rating. In contrast, MSCI, a large ESG-rating agency, states that it uses no questionnaires, and relies on government and NGO public data and 2,100 media sources.

How do MSCI and other agencies assess the environmental footprint of a company? Some of the data that they use, including toxic-emissions data of prescribed chemicals, come from the Environmental Protection Agency and violations and sanctions imposed by the EPA (Note: The EPA does not prescribe what levels of emissions are considered toxic). Other rating agencies have relied on the Carbon Disclosure Project for data on a firm’s carbon footprint. But that data is voluntarily supplied by a few firms that want to participate. It is not clear whether these carbon-footprint data are uniformly audited.

Moreover, what trade-offs do firms make in reducing their carbon footprint? If reducing the carbon footprint was relatively costless, why was such a reduction not achieved before? The output, in most cases, is a relative and not absolute measure of goodness. If the objective is to prevent global temperatures rising by 2 degrees Celsius over the next century, relative goodness doesn’t move the needle.

How does an ESG-rating agency assess the social impact of a company? A big component is the firm’s relations with its workforce. However, U.S. companies are notorious for not even disclosing their labor costs, let alone fine-grained data on corporate culture, gender composition of their workforce, the training their workers get, the wage disparity between the sexes in their company, the extent of employee turnover and so on.

And what about governance practices? While proxy advisory firms play an increasingly important role in influencing shareholder votes, research suggests that commercial governance ratings of firms are not informative.

Greenwashing

ESG ratings rarely delve into why some firms have higher scores than others, leaving these ratings open to greenwashing, which is sometimes used to promote the perception that a company’s products, aims, or policies are environmentally friendly. Indeed, research shows that firms afflicted by scandals tend to invest abnormally larger sums of money to mend fences with their shareholders. But it is not clear whether ESG-rating agencies flag greenwashers separately from genuinely good ESG companies.

This may help explain BlackRock’s recent study finding that companies adhering to ESG practices are more likely to encounter lawsuits and regulatory actions, stating: “Like most observers, we expected common ESG practices to be associated with better social performance. We were wrong.”

Self-selection

Several studies claim that companies who rate highly on ESG earn alphas, or abnormal returns. In our experience, that claim is overstated for three reasons. First, already successful firms are more likely to invest in ESG activities, suggesting that higher ratings actually pick up successful firms.

Second, the returns from firms with high scores have been attributable to sector-wide performance. For example, technology stocks are regularly ranked as high ESG firms and that particular sector has outperformed the broader market in recent years. On the other hand, stocks of resource-heavy sectors, such as oil and gas, which are ranked lower, have performed poorly over the same period.

Third, sheer investor demand for stocks with high ESG ratings, which are potentially unreliable, can push stock prices higher, yielding alphas.

Risk management

To us, impact investing is like investing in any other risky endeavor. The investor must assess the possibility that the project will yield sufficient risk-adjusted returns to justify the investment, as well as deliver the targeted societal benefits. The challenge is whether and how to trade off the two to create a quantifiable investment objective.

We urge investors and stakeholders to take a hard look at the ratings provided by ESG-rating agencies. To be clear, both of us believe that climate change is a real concern and firms could do well by doing good. Identifying which firm is doing well by doing good, however, is a non-trivial exercise.

 

Email a friend

Please complete the form below.

Required fields *

*
*
*

(Separate multiple email addresses with commas)