New paper examines ESG ratings effectiveness (2022)
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On August 4, 2022, David Larcker and Brian Tayan of Stanford, Edward Watts of the Yale School of Management, and Lukasz Pomorski of AQR Capital Management published a paper examining the reliability and effectiveness of ESG ratings. The paper, titled “ESG Ratings: A Compass without Direction,” found that ratings tended to fall short of their claims on both counts.[1]
“In this Closer Look, we examine these concerns. We review the demand for ESG information, the stated objectives of ESG ratings providers, how ratings are determined, the evidence of what they achieve, and structural aspects of the industry that potentially influence ratings. Our purpose is to help companies, investors, and regulators better understand the use of ESG ratings and to highlight areas where they can improve. We find 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.”
Among other specific critiques, the authors noted the following:
“Having reviewed the objectives and methodological choices of ESG firms, we can better understand the research evidence regarding ESG ratings quality, consistency, and effectiveness. Unfortunately, it is rare for ratings providers to offer concrete, systematic evidence to back up claims about their ratings. ...
"Systemic patterns are observed in ESG ratings. One pattern is related to company size: Large companies receive higher average ratings than smaller companies. This might be due to the more significant resources large firms are able to invest in ESG initiatives, or it might be due to the fact that large companies have greater disclosure of ESG data. A second pattern is industry-related: While some ESG ratings are industry adjusted, those that are not may have higher average scores for certain industries (such as banks and wireless communications) than for others (such as tobacco and gaming). It is not clear if these patterns are due to fundamental differences in ESG quality across industries, or a result of the methodological choices and input variables that underpin ESG ratings models. A third pattern is country-related: European companies have higher average ESG scores than U.S. companies, which might be due to political and regulatory differences across countries. Firms in emerging markets also have lower ratings than firms in more developed economies. ...
"Studies find that ESG ratings have low associations with environmental and social outcomes.
"A review of MSCI ratings conducted by Bloomberg finds that most upgrades occur for what Bloomberg calls “rudimentary business practices” rather than substantive improvements. In justifying 155 upgrades, MSCI cited governance improvements almost half (42 percent) of the time—significantly more than social (32 percent) or environmental (26 percent) improvements. Upgrades were often driven by check-the-box practices, such as conducting an employee survey that might reduce turnover, and rarely for substantial practices, such as an actual reduction in carbon emissions. Half of companies were upgraded for doing nothing—the result of methodological changes.
"Raghunandan and Rajgopal (2022) find that companies in ESG portfolios (those with high Sustainalytics ratings) have worse records for compliance with labor and environmental laws relative to companies in non-ESG portfolios during the same period. Companies added to ESG portfolios also do not subsequently improve compliance with labor or environmental regulations.”
See also
- Environmental, social, and corporate governance (ESG)
- Economy and Society: Ballotpedia's ESG newsletter
External links
Footnotes
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