Bottom Line: Environmental, Social, and Governance (ESG) ratings, on which investors increasingly rely, are flawed. They lack standardization and disclosure requirements as well as suffer from company size, geographic, and industry biases. To be a more useful and accurate guide for investors, ESG rating agencies must standardize analyses of disclosed information, adjust for biases, increase transparency, and disclose their success rates.
The number of investment funds incorporating ESG criteria grew from 260 in 2007 to more than 1,000 in 2016. As the popularity of ESG investing has increased, so too has the influence of ESG rating agencies, which offer the increasing number of investors interested in ESG strategies data to support ESG evaluation. MSCI, a leading provider of ESG ratings, says it provides ratings for 46 of the top 50 global asset managers.
Yet these ratings are often flawed and non-objective. They can vary dramatically among divergent ESG rating agencies due to differences in methodology, subjective interpretation, or an individual agency's agenda. There are also inherent biases, from market cap size, to location, to industry or sector — all rooted in a lack of uniform disclosure.
1. Disclosure Limitations and Lack of Standardization: There are no standardized rules for Environmental and Social disclosures, nor is there a disclosure auditing process to verify reported data.
2. Company Size Bias: Companies with higher market capitalization tend to be awarded ratings in the ESG space that are meaningfully better than lower market-cap peers.
3. Geographic Bias: Regulatory reporting requirements vary widely by region and jurisdiction — with two companies active in the same industry, doing the same general thing, often assigned different scores based on where they are headquartered.
4. Industry Sector Bias: Company-specific risks and differences in business models are not accurately captured in composite ratings.
5. Inconsistencies Between Rating Agencies: Individual company ratings are not comparable across agencies, due to a lack of uniformity of rating scales, criteria, and objectives.
6. Failure to Identify Risk: One of the purposes of ESG ratings is to evaluate risk and identify misconduct. ESG ratings do not properly function as warning signs for investors in companies that experience serious mismanagement issues.
As a result of these flaws, ESG investing may conflict with investors' fiduciary duty to maximize investment returns.
1. ESG information already disclosed in regulatory filings should be standardized to incorporate risk.
2. ESG ratings need to adjust for company size, geographic reporting, and industry sector differences.
3. ESG rating agencies need to be transparent on how E, S, and G factors impact scores and prioritize those that are material.
4. ESG rating agencies should be carefully compared and should fully disclose their success rate in protecting investors from large underlying risks.
Read the full report: "Ratings That Don't Rate: The Subjective World of ESG Rating Agencies," by Timothy M. Doyle, Vice President of Policy and General Counsel at the American Center for Capital Formation.