Ed. note: Advisory Board member Tamara Close provides this timely analysis as the EU and IOSCO announced they intend to regulate ESG data providers. This is the second of a two part piece.
In an upcoming academic paper, “Inconsistencies in methodologies of ESG data providers and green bond standards,” authors Kim Schumacher and Tamara Close identify eleven major inconsistencies between ESG data providers based both on the type of data provider and their underlying methodologies. Given differences in ESG ratings, investors would be better-off thinking of them as ESG data “opinions”. Similar to sell-side research opinions which can vary from firm to firm, ESG data providers should serve as an input to the investment process rather than a determination of the underlying issuers’ ESG quality.
Biases
The data providers and raters contain size and geography biases. The materiality of an ESG issue can vary depending on the country or the region[1] of the firm. For instance, while issues such as “worker health and safety” are very important in developed markets, developing markets may favor job creation over health and safety to reduce poverty levels[2]. This may create rating biases in favor of firms in developing countries (unless normalized for regional differences), since most ESG rating agencies tend to be from Western countries.
Biases in ESG company scores may push investment portfolios toward larger cap companies and regions with higher levels of regulatory reporting for sustainability issues. This does not necessarily mean that these are the most sustainable companies in the investment universe.
Therefore, by solely relying on an ESG data provider’s score, investors are “taking on the perspectives of that provider without a full understanding of how the provider arrived at those conclusions.”[3]
Some investors will try to get around this issue by using the underlying raw ESG data from a provider as opposed to the aggregated scores. However, depending on where providers get their data, this can also create unwanted impacts. For instance, most self reported corporate ESG data is not subjected to audits or internal controls and therefore may pose a risk for errors and omissions.
What to Do
ESG data and metrics should also be looked at in a holistic fashion and not in a siloed approach to ensure more clarity into the ESG risk of a company. For instance, comparing two firms’ health and safety processes by simply looking at their reported “near miss accidents” may create unintended consequences in a portfolio. One firm may have higher near misses than another – but is that due to the fact that they have a worse health and safety record compared to another firm or because they have a very transparent reporting methodology and encourage their workers to report all near misses in an effort to constantly improve their health and safety record? A wider investigation and assessment of governance and oversight processes is required to obtain a more holistic and realistic view of a company’s health and safety process.
Sophisticated investors understand that given the inconsistencies between ESG data providers, they need to apply critical judgement and perform an in-depth analysis when integrating ESG ratings into their investment decisions. A crucial first step is the due diligence of any ESG data provider used[4]. These investors will then often overlay their internal knowledge (from internal ESG specialists and/or from engagement with investee companies), and insights from ESG technical experts (such as engineers, scientists, and researchers) onto the raw data from ESG data providers to create their own proprietary ESG scores.
ESG data and data providers certainly have a critical role to play in the investment industry. Providers are solving for the ESG data availability challenge in capital markets by sourcing, analysing and aggregating this data. However, this is also creating subjectivity and biases in portfolios. A thorough understanding of methodologies, as well as the types and sources of data used by ESG data providers is fundamental for investors if they want to use this data as an input to their investment process and create truly sustainable investment portfolios.
[1] For a good overview of the regional differences of ESG issues, see: https://www.hexavest.com/en/esg-factors-applied-to-emerging-markets-a-top-down-case-study/
[2] Ibid.
[3] State Street. 2019. “The ESG data challenge”, https://www.ssga.com/investment-topics/environmental-social-governance/2019/03/esg-data-challenge.pdf
[4] This was highlighted as a recommendation in the recent consultation paper from IOSCO: “Financial market participants could consider conducting due diligence on the ESG ratings and data products that they use in their internal processes. This due diligence could include an understanding of what is being rated or assessed by the product, how it is being rated or assessed and, limitations and the purposes for which the product is being used.” Source: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD681.pdf
