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Why ESG ratings are still seriously flawed



Those who rely too heavily on ESG ratings may be disappointed. Ratings don’t always actually reflect a company’s ESG performance. Multiple and fundamental weaknesses are to blame​

by Justus Fischer

Wiesbaden, October 8, 2021. ESG ratings play a supporting role in investment decisions. Investors and analysts rely on the ratings and assess a company’s ESG performance based on them. For example, 65 percent of investors surveyed in the Rate the Raters study said they use an ESG rating at least once a week. This is despite their criticism in that very study that ratings can contain errors or draw on old data. But ESG ratings have other fundamental flaws that make objective evaluation impossible.

Methodology Chaos

A study by the MIT Sloan School of Management showed that ESG ratings from six different providers differed widely, with a correlation of 0.54. By comparison, the correlation for credit ratings is 0.99. That’s because ESG rating agencies such as MSCI, Sustainalytics and ISS use different criteria against which to measure companies’ performance. This also explains how Volkswagen scored 0 out of 100 in MSCI’s ESG rating, but 65 out of 100 in RobecoSAM’s rating.

Anyone trying to find their way through this chaos will have a hard time. Many rating agencies do not provide information on the criteria and weightings by which they conclude their final rating in the first place. And even if they do disclose information on this, it is difficult to find one’s way around them. For example, Sustainalytics regularly finds that a company has not met any of the required criteria in an area such as “Environmental Policy,” but still awards 25 out of 100 points.

No sense in ESG ratings

The “Board Diversity” area also makes little sense in Sustainalytics. Here, the following criteria are present: “There are no women on the board,” “There is only one woman on the board,” “Two or more women serve on the board, but less than one-third of the board is female,” and “Women constitute one-third or more of the board’s membership.” Suddenly, the agencies can also select negative criteria and use them for the evaluation. But how many points or minus points there are for the respective criteria and how they affect the result remains open. This makes it difficult for companies to assess how they can improve their rating at all.

All these points are confusing enough. But ESG rating agencies have another ace up their sleeves: Some change their criteria so much from one year to the next that companies suddenly have completely different requirements to achieve a good ESG rating. MSCI has done this in the pharmaceutical sector, for example. As a consequence, the extent to which pharmaceutical companies have changed positively or negatively from one year to the next cannot be measured at all.

Worse from the bottom up

One group of companies in particular is disadvantaged in ESG ratings: SMEs. It turns out that these perform worse on average than large companies, even if they act just as sustainably. This is merely because of the fact that they provide less data. However, SMEs have significantly fewer resources at their disposal to conduct sustainability reporting that is as detailed as that of large companies. Yet, ESG rating agencies do not compensate for this problem through their analysis.

As you can see, ESG rating agencies still have some work to do if they want to assign truly objective and helpful ratings. Defining the term “sustainability” and being more transparent about how ratings are created would also help. Another problem is that many companies don’t even know that ESG rating agencies have already rated them. More communication in this area would help.

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Justus FischerJustus Fischer: Senior Consultant
Justus Fischer has gained experience in various ESG and IR communications projects. He coordinated a cross-media content marketing campaign for an international technology group. Justus studied media studies, rhetoric and literature at the universities of Tübingen, Bielefeld and La Plata (Argentina).