ESG (environmental, social, and governance) ratings providers are becoming increasingly influential in today’s financial markets. However, ESG ratings from different providers diverge, creating a challenge for decision-makers and investors.
The Review of Finance recently published "Aggregate Confusion: The Divergence of ESG Ratings", by Florian Berg, Julian Kölbel and Roberto Rigobon, as the lead article in their Special Issue on Sustainable Finance.
The paper investigates why ESG ratings diverge. The analysis is based on data from six prominent ESG ratings providers. They documented an average pairwise correlation between these ESG ratings which ranges from 38% to 71%. They concluded while ESG ratings rarely provide diametrically opposing assessments, the dispersion makes it difficult to identify businesses that are ESG leaders from average performers.
To explain the reasons for divergence, they use a dataset that consists of the aggregate ratings along with the full set of underlying indicators. They categorize all indicators into a common taxonomy of 64 attributes and re-estimate the original ratings based on this taxonomy.
They decomposed the divergence into three components: scope, measurement, and weights. Scope divergence means that ratings are based on different sets of attributes. Measurement divergence means that rating agencies measure the same attribute using different indicators. Weights divergence means that rating agencies assign different weights to attributes when aggregating them to a single rating. Their findings suggest that measurement is responsible for 56% of the overall divergence, scope for 38%, and weights for 6%.
Interestingly they advocate that the rating provider’s overall view of a firm influences the measurement of specific categories. Suggesting that measurement divergence is not just randomly distributed noise but has structural reasons as well. Taking an ESG rating off the shelf and assuming that it's an objective measure of ESG without fully understanding what it's actually measuring is clearly a challenge. Obviously different people have different views on what's material for a company's long-term financial performance, and what's material for society independent of its impact on company performance.
ESG rating divergence highlights that measuring ESG performance is challenging, that attention to the underlying data is essential, and that the use of ESG ratings and metrics must be carefully considered for each use case. This piece of research may be useful for Investors to use their methodology to reconcile diverging ratings and focus their research on those categories where ratings disagree. For regulators, the study probably further highlights the potential benefits of harmonizing ESG disclosure and establishing a taxonomy of ESG categories. Harmonizing ESG disclosure would help to provide a foundation of reliable data. A taxonomy of ESG categories would make it easier to contrast and compare ratings within this common taxonomy.
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