By CFA Society Chile

ESG ratings in sustainable investment 

ESG ratings offer a practical solution practical solution for integrating numerous factors into a final assessment, thus simplifying the complex work of analysis. However, this simplification can be problematic when trying to understand the origin of the assessments and the large differences in results between different providers. This challenge is particularly relevant in sustainable investment, where transparency and consistency in assessment are crucial.

In collaboration with Pictet Asset Management, I had the opportunity to co-lead an article addressing the issue of ^ESG1 ratings and metrics.. In it, we analyzed the low correlation between ESG rating providers, averaging 54%, in contrast to the high correlation of 95% observed between different credit rating ^agencies2, according to an ^MIT study3. This divergence is due to several reasons, including different measurement approaches, the scope of the attributes considered and differences in the weighting of the factors evaluated.

What are the sources of divergence? 

The main source of divergence, accounting for 56% of it, is the measurement approach. This means that, for the same attribute, different metrics may be used. For example, in the case of health and safety, some suppliers may focus on the number of workplace accidents, while others may consider employee turnover. The second divergence factor is scope, which explains 38% of the variability. Some suppliers may include certain attributes in their assessments, while others omit them. Finally, differences in the weighting of the factors explain the remaining portion of the divergence. The way in which each supplier assesses and weights the different ESG factors can vary significantly, resulting in different final ratings.

What are the uses of ESG ratings? 

Despite these limitations, ESG ratings can be a valuable tool for investors, provided that their methodologies are understood and their limitations are considered. In the article, we address both the positive aspects and limitations of ESG ratings. On the positive side, investors can use the ratings to make comparisons between different providers, This allows them to get a more complete picture of an issuer's ESG risks and opportunities. In this sense, they can be taken as different recommendations or opinions. In addition, ESG ratings are used ESG ratings are used by passive investors to construct indices that exclude issuers with weaker ratings or focus on weaker issuers. ratings or focus on the strongest issuers.

What are the limitations of ESG ratings? 

However, we also highlight several important limitations in the article. First, given the existence of different methodologies for assessing ESG risks and opportunities, it is crucial to analyze them when selecting a supplier, although this information is not always easy to access, it is crucial to analyze them when selecting a supplier, although this information is not always easily accessible. Second, and perhaps the most significant limitation, is the tendency to combine the three ESG pillars. tendency to combine the three ESG pillars into a single sustainability report. This can lead to the averaging of unrelated aspects, resulting in assessments that do not adequately reflect specific risks.

For example, a company that consumes a lot of energy in its operations, but is at the forefront of energy efficiency and has increased its share of renewable energy could receive a good environmental assessment. However, if the same company has numerous workplace accidents and faces workplace safety claims, its social assessment would be poor, its social assessment would be poor. Averaging these two assessments could result in an average rating that does not adequately capture the risks and opportunities in each area.

Methodology and deepening 

In conclusion, while ESG ratings are a useful tool for integrating sustainability aspects into investment processes, it is essential to understand their limitations and methodologies. Investors should avoid evaluating companies solely on their overall ESG rating and instead delve deeper into the specific assessments of each of these sustainable pillars. By doing so, they will be able to gain a more accurate and detailed view of the risks and opportunities associated with each company, thereby improving the quality of their decisions and making their investments more sustainable.

By Daniela Mohr

¹https://www6.cuprum.cl/sostenibilidad/trabajo-colaborativo
^2KevinPrall, CFA, "ESG Ratings: Navigating Through the Haze".
^3Berget al. (2022), "The Aggregate Confusion: The Divergence of ESG Ratings."