Sustainable Investing: The Black Box of Environmental, Social, and Governance (ESG) Ratings

Environmental, social, and governance (ESG) investing is becoming mainstream, and the COVID-19 pandemic has amplified the momentum. The interest in ESG investing creates greater demand for ESG data, ratings, and rankings, spawning a proliferation of agencies offering these products, which investors, academics, and regulators rely on unquestioningly. Research highlights that different ESG ratings and rankings produce significantly different assessments of the ESG performance of companies. This article examines the causes of differences in the ratings and rankings generated by different agencies. Findings indicate that the divergences among raters can be attributed to differences in the definitions of ESG constructs (i.e., a theorization problem) and methodological differences (i.e., a commensurability problem). While users of ESG ratings and rankings are advised to study the definitions and methodologies before their use, a lack of transparency about the data sources, weightings, and methodologies makes it difficult to ensure that companies’ true ESG performance is accounted for when making portfolio selection and investment decisions. As a solution, the article notes that instead of attempting to compare and contrast ratings and rankings of different agencies, investors should determine the ESG constructs that are material to their own investment strategies and then match them with an ESG rating or ranking product that closely resembles those constructs. TOPICS:ESG investing, information providers/credit ratings, portfolio construction, portfolio theory Key Findings ▪ There are significant divergences among the ratings and rankings provided by different ESG rating agencies. ▪ Differences among various ESG ratings and rankings are caused by differences in the definitions of ESG constructs (i.e., a theorization problem) and differences in the methods applied for measuring ESG performance of companies (i.e., a commensurability problem). ▪ Agencies providing ESG ratings and rankings are not transparent about what constitutes ESG performance and how ESG performance is measured, including information sources used. ▪ Theorization, commensurability, and transparency problems contribute to masking the true ESG risks and the performance of companies.