“Significant Shortcomings” Found in Current State of ESG Ratings

ESG ratings published by ISS, MSCI, Sustainalytics and dozens of others continue to proliferate, but lack evidence to back up their claims, according to David Larcker and his colleagues at the Stanford Rock Center for Corporate Governance.  In their recent paper ESG Ratings: A Compass Without Direction, the authors conducted a review of the methodologies and reliability of the ratings produced by the leading ESG rating organizations and conclude that “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.”  

Specific shortcomings identified by Larcker et al include:

• ESG ratings are intended to measure ESG quality although this concept has no agreed-upon definition.
  
  
• Ratings frameworks are dramatically different, analyzing a wide range of input variables (300 to 1,000 factors) representing a mix of public information and hypothesized or theoretical relationships that have not been tested.  The absence of standardization and consistency detracts from the usefulness of the ratings.
  
  
• Across the leading providers of ESG ratings, the authors note the low correlations of their ratings.
  
  
• Conflicts of interest due to the sale by advisory firms of consulting services to rated companies are a problem: “These firms benefit from the use of ratings even if the ratings themselves ultimately do not provide reliable information.”

 The limitations of the current state of ESG ratings produces mixed evidence as to their usefulness in predicting “investment risk or return” or “improvements in stakeholder outcomes.” Unfortunately, they are increasingly relied upon by individual and institutional investors when making investment decisions. One suggestion, made by the authors, would be to regulate ESG ratings agencies the same way credit rating agencies (Moody’s, Standard & Poor) are regulated.