Ratings that Don’t Rate: The Subjective World of ESG Ratings Agencies

Timothy M. Doyle is Vice President of Policy and General Counsel at the American Council for Capital Formation. This post is based on an ACCF memorandum by Mr. Doyle.

As the trend of Environmental, Social, and Governance (“ESG”) investing has risen, so too has the influence and relative importance of ESG rating agencies. With an increasing focus on social corporate responsibility, the ability to project a positive image around ESG-related topics is critical. As such, more companies have begun making select and unaudited disclosures in an effort to attract ESG-investing capital. The arbiters for obtaining this capital are the major ESG rating agencies.

However, individual agencies’ ESG ratings can vary dramatically. An individual company can carry vastly divergent ratings from different agencies simultaneously, due to differences in methodology, subjective interpretation, or an individual agency’s agenda. There are also inherent biases: from market cap size, to location, to industry or sector—all rooted in a lack of uniform disclosure.

Tellingly, many of the issues highlighted in the complete publication (available here) mirror failings we found in the proxy advisory industry (explored in a previous ACCF report, “The Conflicted Role of Proxy Advisors”). There, a history of conflicts of interest, inadequate voting guidance, and opaque business practices, raise serious questions about the ability of the industry to provide impartial and accurate recommendations.

Taken in conjunction with the issues identified here, the two papers collectively suggest that there are substantial challenges with the quality of information that investors are using to both deploy ESG focused capital and vote stock options.

The complete publication (available here) seeks to evaluate ESG ratings agencies to support investors in understanding the current state of play in the ESG ratings industry. Ultimately, we found significant disparities in the accuracy, value, and importance of individual ratings, for reasons including:

  • Disclosure Limitations and Lack of Standardization: There are no standardized rules for Environmental and Social disclosures, nor is there a disclosure auditing process to verify reported data; instead, agencies must apply assumptions, only adding to the subjective nature of ESG ratings. The lack of transparency and reliance on unaudited data is not dissimilar to the findings presented in a previous ACCF report on the conflicted nature of proxy advisors.
  • Company Size Bias: Companies with higher market capitalization tend to be awarded ratings in the ESG space that are meaningfully better than lower market-cap peers, such as mid-sized and small businesses.
  • Geographic Bias: Regulatory reporting requirements vary widely by region and jurisdiction—with two companies active in the same industry, doing the same general thing, often assigned different scores based on where they are headquartered. Companies domiciled in Europe, in particular, often receive much higher ESG ratings than peers based in the United States and elsewhere.
  • Industry Sector Bias: Company-specific risks and differences in business models are not accurately captured in composite ratings. Because of significant differences in business models and risk exposure, companies in the same industry are unfairly evaluated under the same model.
  • Inconsistencies Between Rating Agencies: Individual company ratings are not comparable across agencies, due to a lack of uniformity of rating scales, criteria, and objectives.
  • Failure to Identify Risk: One of the purposes of ESG ratings is to evaluate risk and identify misconduct. ESG ratings do not properly function as warning signs for investors in companies that experience serious mismanagement issues.

The complete publication is available here.

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  1. michael schewel
    Posted Tuesday, August 7, 2018 at 10:16 am | Permalink

    The reason these rating agencies don’t really focus on risk is that the raters aren’t really interested in company performance, they are interested in social policy. They cloak that interest under the guise of “sustainability of company earnings” or some such. If that’s what they were really interested in (company performance), that would be the key focus of their ratings.

  2. Nell Minow
    Posted Tuesday, August 7, 2018 at 11:44 pm | Permalink

    The deceptively public-minded name of this organization is intended to obfuscate its real funders (corporate executives) and its real goal (preventing oversight by large, sophisticated financial institutions managing millions of shares of stock as fiduciaries for beneficial holders). ESG ratings are still developing. They must rely on limited and often misleading disclosures by companies (which is why this organization and its affiliate, the similarly obfuscatory Main Street Investors Coalition) are really all about suppressing shareholder votes through lobbying and misleading arguments and slanted “research.” All securities analysis is subjective. No matter how much match is involved, the selection and weighting of data points is qualitative. That’s what makes markets. The question is whether large, sophisticated investors find it to be of value as they do the (completely biased and unreliable) rankings of the ratings agencies or the (usually biased) recommendations of securities analysts. If they want any or all of these things to help them make their decisions, and if they have to submit or support shareholder resolutions calling for more disclosure to make them even more valuable, it is not the business of a fake front group like this to tell them “pay no attention to the man behind the curtain.”

  3. Alan
    Posted Wednesday, August 8, 2018 at 3:35 am | Permalink

    Individual company ratings are not comparable across agencies, due to a lack of uniformity of rating scales, criteria, and objectives.”

    This is like saying real estate firms should only build houses that have exactly the same specs.

    The reason for different ratings scales, methodologies, criteria and objectives are the different priorities of the various asset managers and asset owners that subscribe to these services. Few AO’s or AM’s have the same investment objectives.