Multi-Factor Design

The Evolution Of Single-Company ESG Ratings

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Multi-Factor Design

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Environmental, social and governance (ESG) investing is a major force with more than $20 trillion in assets. But, for it to succeed, investors need to know that companies are reliably achieving their ESG promises. This need has driven the growth of single-company ESG scores generated directly by ratings providers from the dozens of ratings they provide covering more granular issues. The single rating delivers a comparable rating across multiple ratings agencies, which, due to divergent approaches on underlying ratings, cannot otherwise be easily supported.

The days of solely implementing negative screening, excluding “sin stocks” or oil and gas companies, are long past. ESG integration is now a major focus of Wall Street and along with recognition of real progress achieved comes some warranted skepticism. The Remarkable Rise of ESG, a short piece that appeared in Forbes, did an excellent job of walking through the early days of ESG/SRI and how far we have come. More recently, How Socially Responsible Investing Lost Its Soul, by Rachel Evans of Bloomberg BusinessWeek, suggested a wake-up call, warning that Wall Street is predictably churning out ESG products that will disappoint naïve but well-intentioned investors. Taking just one aspect of where we are today, the single-company ESG rating, this can be used to check our current position on the evolution of ESG investing and help us to project where we are likely headed from here.

Clearly integrating a single ESG company rating into investment processes is quicker and less taxing than deciding how to incorporate over 30 individual ratings per company. The single rating is a summary of underlying ratings or scores on that company from a ratings vendor covering ESG issues. Without judging if a single rating is a perfect metric, we can agree that it is easy to understand, compare one company to another and to support decisions. ESG analysis has evolved to the stage where the single-company rating is widely produced and leveraged.

As an active participant in risk and quantitative investment analytics, the evolution of ESG factors, research and investing has been a captivating journey. With the single-company rating, it is hard not to reflect back on the positioning of value at risk (VaR) as the best single measure of risk (at least before 2008). While practitioners knew a single risk measure was not a full answer to any question, there was not a lot of effort made to broadly educate and communicate the known limitations. Vendors pushed their systems’ abilities to calculate VaR, increasing emphasis on a single number as a panacea for a very complex reality. To be fair, ESG ratings don’t forecast potential losses, but there are some parallels in their rise to prominence.

A lot has been written on the inconsistency of vendor-supplied ESG ratings. CRSHub did a study in 2018 and found the correlation (r-squared) of company-level ESG ratings using two leading vendors was only 0.32 (pretty low versus 0.90 in its sample for credit ratings). Those statistics will not surprise practitioners.

Let’s start with positives and negatives about leveraging a single ESG rating.

The good – A single score drives more widespread access to ESG analysis, facilitates investment decisions and grows revenue for asset managers. The two largest ESG ratings agencies, MSCI ESG and Sustainalytics, have grown their usage based on single scores. The focus on single-company ratings comes down to revenue and the fact that it is the practical first choice for over 80% of asset managers and investors, for the following reasons:

  • More investment decisions can be powered by ESG ratings. It supports marketing that is successful with broad audiences.
  • A top-level score is a great first step in a screening process or monitoring companies. This provides an improved and more sophisticated approach than negative screening by industry (e.g., oil and gas or tobacco).
  • People want easy answers, not lots of data and questions. Looking at individual ratings within, say, the governance category leads to confusion. Even if a company-level ESG rating is inconsistent with another credible source, or important underlying factors show high risk, the need for an answer wins.
  • Single-company ratings allow for balance between when companies are doing well and when headlines highlight undue risk.
  • It mutes out known, unresolved biases. There are well-documented issues that show problems with ratings related to size, geography and industry. Several studies have pointed at these findings including Ratings that Don’t Rate, by the American Council for Capital Formation. MSCI ESG literature claims size (financial capacity) allows for more resources to be focused on ESG issues, which would artificially support higher ESG scores.

Read the full article here by Dave Merrill, Advisor Perspectives

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