Standard environmental, social and governance (ESG) ratings could be polluted by three traditional investment factors that account for close to 50 per cent of observed corporate financial performance, according to a new study by index provider FTSE Russell.
The FTSE Russell analysis found that “almost half of the information contained in the ESG ratings is explained by three factors: size, activity, and country”.
“Surprisingly, perhaps given the rising importance of ESG as an investment theme, so far there seems to be scant academic evidence… of how much size, country and sector account for in an issuer’s overall score,” the report says.
ESG ratings has grown to an almost billion-dollar-a-year global business in recent times as fund managers and index providers scramble to meet the burgeoning demand for ‘responsible investment’ products.
But off-the-shelf ESG scores, provided by the likes of the Morningstar-owned Sustainalytics and MSCI, often yield different results for the same company, highlighting the lack of data standardisation in what remains a very subjective analytical field.
In March this year, Axel Pierron, managing director of European research house Opimas, said the wide variety of ESG data quality and different research methodologies presented a dilemma for investors.
“The issue ahead is that the industry is likely to see a massive reallocation of portfolios toward companies that have better ESG ratings solely based on incomparable data,” Pierron said. “Investors will end up with stocks that are overpriced due to — at best — incomplete or outdated data.”
FTSE Russell says in the study that even after “years of research and debate”, there is only tentative industry consensus on the benefits of ESG analysis.
Furthermore, the report says “no formal agreement has been internationally ratified that would stipulate what [ESG] indicators should be required information for performance assessment and wider impacts evaluation”.
In its analysis, FTSE Russell found the significant effect of size, sector and country factors on ESG scores was persistent over time.
The outsize influence of all three factors on ESG scores does have rational explanations, the study says. For instance, large companies tend to report more on ESG issues as they face more substantial reputational risks and greater market scrutiny than smaller firms. Similarly, certain countries and industries (such as the fossil fuels sector) naturally fare worse in current ESG rating methodologies.
And while those biases might be difficult to untangle from the ESG ratings process, the study says they should be adjusted for in performance attribution.
The FTSE Russell approach separates out the three-factor “explained” ESG score from a “residual” component.
But it is “too early to answer” the question of whether the ‘residual’ score – arguably the true measure of any ESG edge – “helps towards a better financial performance”, the report says.
FTSE Russell plans a series of further studies to build deeper understanding ESG ratings biases and how to control for them.
The first analysis was authored by a FTSE Russell panel including head of sustainable investment innovation research, Valéry Lucas-Leclin.
Owned by the London Stock Exchange Group, FTSE Russell bought ESG fixed income analytical firm, Beyond Ratings, last year. The global financial index behemoth, also has a growing range of ESG-themed benchmarks, including some built with Sustainalytics under an agreement inked late in 2018.