Here's Why Ethical Investors Need Be Wary of ESG Scores

 As the financial market, especially investors, increases their attention on corporate sustainability, so have the companies disclosing their ESG data. The shift has also increased the number of agencies evaluating performance and releasing ESG ratings. However, the diversity of sources has led to significant differences in ratings, and ethical investors are becoming wary of the scores.

The lack of a standardized ESG score framework makes it difficult to ascertain how an individual score has been determined. There are significant discrepancies in how companies analyze their data, tabulate, and assign scores. Third-party rating providers may use unique scoring systems and metrics or sort the criteria distinctly within the three primary components of ESG. A company can have varied ESG ratings despite using the same standards to rate companies.

What Is An ESG Score?

An ESG score is a quantitative metric, such as a letter or numeric score, rating an organization's social, environmental, and governance efforts. The rating measures to what extent organizations execute their ESG goals as they endeavor to identify what benefits they can provide.

Why ESG Scores May Not Fully Serve An Ethical Investor

The ESG ratings of companies are substantially varied. So much so that a company could have a great ESG score in one rating and an extremely low one in another. Counting on ESG scores to make ethical investments could lead to misinformed decisions. Several challenges related to methods and data used in ESG scoring lead to discrepancies between ratings from multiple companies. They include:

Lack of Standardization of the Rating Methodology

An ESG score is a score assigned to an entity per its performance rated against a given set of sustainability indexes and indicators. Each ESG rating agent develops a method of weighing and measuring every particular factor.

Therefore, personal views on the significance of every factor influence the decision on the methodology. Their opinions also affect their take on whether a good performance on an element is enough to compensate for poorer performance in another. 

The following are three factors that often result in divergence.

●Weight divergence occurs when different agencies assign different degrees of significance to each attribute—for instance, valuing human rights more than corporate lobbying.

● Scope divergence may occur when agencies include and exclude some factors in their metrics. For instance, one may consider human rights, corporate lobbying, gas emissions, and employee turnover in its ranking, while another does not consider lobbying.

● Measurement divergence happens when different agencies measure a similar aspect through various indicators. One agency can weigh a company’s labor practices by checking the number of labor suits against the company, while another base its measurements on workforce turnover. While each approach will identify an aspect of the company’s labor practices, they will likely have different assessment results.

● The lack of a uniform method can lead to very different ESG rankings of the same company. The absence of a standard approach can misrepresent an organization’s ESG commitment when limited sources are implemented during the decision-making. Therefore, investors must be wary of third-party ratings.

● The rater effect is where an agency's assessment of an organization’s individual categories somewhat influences their overall view of the organization — especially when the company has tested positively for a given indicator like labor practices or human rights. Research has shown that agencies are inclined to rank the rest of the indicators positively in their overall ESG scores.

Structural Bases in the Rating Assessment

ESG ratings fundamentally depend on the disclosure of company processes, which can lead to a significant bias. The dependence on favor can cause an inclination in ESG scores that favors:

● Larger companies because they tend to report on their ESG factors in a broader proportion. They also have enough resources to get specialists and consultants to answer their questionnaires.

●English-speaking organizations. English-speaking analysts predominantly do research.

● Companies that are more informed on the size and resultant influence of making sustainable investments.

The bias in the ranking assessments can distort the ability to get a company’s actual ESG performance.

Acquisition and Processing of Data

Ranking agencies use varied processes to obtain a company’s, for instance, through employee surveys, workshops, meetings, interviews, and sustainability reports. Many agencies utilize in-house statistical models to approximate estimates based on market trends and averages to handle unreported data and any form of data inconsistency.

The diversity of the data collection processes, inconsistency in data, and the different models utilized for estimation lead to further divergence in ESG scores of companies across different agencies. 

Proceed With Caution

Until there is a standardization model, the scores will continue to differ due to agencies' processes to confirm the accuracy of the data collected. There needs to be more clarity on the procedures that deal with data assessment and consistency processes. There’s also the question of transparency on the methods used to measure sustainability.

The ambiguity and discrepancies in ESG rankings impede prudent decision-making by not just ethical investors, consumers, and the companies themselves. ESG ratings cannot be entirely depended on when making investment decisions that will contribute to actualizing an environmentally sustainable and socially equitable economy.