- The booming business of rating companies based on their environmental, social and governance (ESG) performance is flawed by inadequate standardization and incomplete and inconsistent data, according to a Stanford University study.
- “Demand for ESG information has exploded in recent years,” the study said. “While ESG ratings providers may convey important insights into the nonfinancial impact of companies, significant shortcomings exist in their objectives, methodologies and incentives which detract from the informativeness of their assessments.”
- Conflicts of interest have emerged as ESG rating providers rate affiliated companies or sell consulting services to rated companies, according to the study. Auditors and financial advisors benefit from the use of ESG ratings that do not offer reliable insights to retail investors.
Investors, lawmakers, activists and other stakeholders in recent years have called on companies worldwide to provide detailed disclosure on ESG performance, prompting regulators to draw up reporting standards and schedules.
The EU has mandated that 49,000 companies across the region must begin sustainability reporting next year.
In the U.S., the Securities and Exchange Commission (SEC) is drawing up rules that would require companies to regularly file detailed disclosures on climate risks, including their carbon emissions and those of their energy suppliers.
Investors with $130 trillion in assets under management want companies to disclose such risks, according to SEC Chair Gary Gensler. The coming SEC rule will “provide investors with consistent, comparable, and decision-useful information for making their investment decisions and would provide consistent and clear reporting obligations for issuers,” he said in March when describing the disclosure rule.
Currently, investors may struggle to find consistency in ESG ratings, according to the Stanford study. Reports by dozens of firms in the “highly fragmented” ratings industry lack uniformity and frequently conflict in their assessment of the same company.
“The divergence of ESG ratings has several implications,” the Stanford study said. “One is the potential to confuse investment decisions by giving unreliable information about the ESG quality of firms.”
Conflicting ESG ratings confuse the disclosures made by fund managers about the ESG quality of their portfolios, the study said. Inconsistent ratings also discourage companies from improving their ESG performance by sending an unreliable message on the assessment of their ESG initiatives.
Institutional investors use ESG ratings to build investment portfolios and attract investment from retail investors, often charging higher fees than managers of non-ESG funds, the study noted. “Are institutional fund managers properly motivated to ensure that the ESG ratings they rely on to create these funds are reliable in predicting risk or performance?”
ESG ratings aim to assess a company’s ESG program and risks from social or environmental factors, yet “current evidence is mixed” on whether the ratings predict investment risk or return, the study said. “It is also increasingly unclear whether they capture or predict improvement in stakeholder outcomes.”
ESG rating firms often fail to substantiate their methodology and findings, the study said. “It is rare for ratings providers to offer concrete, systematic evidence to back up claims about their ratings.”
Noting that the SEC holds credit rating agencies to standards aimed at averting conflicts of interest and sustaining market confidence, authors of the Stanford study ask, “should ESG ratings be subject to similar requirements?”