The wide variations between environmental, social and governance (ESG) ratings means they may not be effective at achieving the sustainability objectives of investors, and possibly work against them, according to research from Dimensional Fund Advisors.
Will Collins-Dean, senior portfolio manager, and Eric Geffroy, senior investment strategist at Dimensional Fund Advisors said in a report that the correlation between the ESG scores of different ratings providers has been estimated at just 0.54, compared to a 0.99 correlation between credit ratings from Moody’s and S&P (see graph).
The correlation falls even further between individual E, S, and G components and it is challenging for investors to understand the discrepancies due to the lack of transparency in how the ratings are assigned.
Dimensional Fund Advisors said, “It is common for a company to be identified as best-in-class by one provider and as just average by another provider. This complexity means that ESG ratings may not be effective at achieving, and sometimes even work against, the sustainability objectives of investors.”
The report cited a recent OECD study which found a positive correlation between the E scores and carbon emissions for two out of three ratings providers, i.e. a strong environmental rating was associated with emitting more, rather than less.
Dimensional’s 2021 also found that “sustainability” funds vary greatly in reducing exposure to greenhouse gas emissions. “One in four US-domiciled “sustainability” branded funds reduce greenhouse gas emissions exposure by only 11% or less compared to the Russell 3000’s emissions exposure,” said the report.
Indices based on ESG ratings may also significantly deviate from one another. For example, the MSCI World SRI Index assigned a weight of more than 12% to Microsoft but excluded Apple and Alphabet at the end of March 2021 according to Dimensional. In contrast, all three companies were overweight in the FTSE Developed ESG Index.
Collins-Dean and Geffroy recommended that investors should first identify which specific ESG considerations are most important to them, and then choose an investment strategy, rather than using generic ESG ratings. They wrote: “Investment professionals should be confident that the ESG data they use can support the value proposition they seek to deliver to their clients.”
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