ESG Ratings: Solution or Starting Point?

Environmental, social and governance (ESG) ratings are a popular way to search for companies that meet specific criteria in a responsible investing agenda. But third-party ratings don’t tell the whole story for investors seeking a comprehensive view of how ESG issues affect return potential—or how companies may improve their ESG performance in future.

Creating a scoring system can help bring rigor and precision to investment analysis for asset managers across the industry. But the apparent authority of third-party ESG scores may mask their limitations. We believe third-party ESG services (such as climate data and portfolio-level ESG calculation tools) can be used as part of an investing toolkit, knowing that even as providers continue to refine their modeling and ingest more data, their ratings remain imperfect and provide only a partial solution.

In our view, there’s no substitute for integrating consideration of ESG factors into fundamental security analysis. Rather than outsource ESG assessments to third-party providers, investors and analysts must conduct in-depth, hands-on research and engage actively with issuers. That approach enables investors to achieve real insight into a business and its activities, and to get a proper understanding of its future prospects as well as its past.

Issues with Third-Party Ratings

Today, third-party ESG ratings represent a static look in the rearview mirror: they don’t reflect a company’s potential for improvement or its vulnerability to possible future risks. These ratings rely partly on nonfinancial information that is self-reported, so scores are based on what a company says, rather than what it’s done. They also draw heavily on automated tools that extract data from websites (“web scraping”). This information may not be wholly reliable, or may even have been planted by companies together with key words that are readily recognized by search bots.

What’s more, large companies that can afford to collect and translate all the necessary data to achieve a rating tend to get awarded higher scores. And in emerging debt markets, where many companies are private, data transparency can be materially weaker than that of public companies, and coverage by ESG data providers often doesn’t exist.

Crucially, corporate ESG ratings do not necessarily measure a company’s impact on the Earth and society. Rather, some simply assess the way a company manages current ESG risks and opportunities in terms of impact on its bottom line. This rating approach focuses on whether a company is protecting its financials, as opposed to taking substantive steps to creating a greener and better world. (By contrast, ESG datapoints such as carbon metrics are already governed by independent standards like those of the Task Force on Climate-Related Financial Disclosures.)