Investors increasingly want the money they invest to reflect their values. Hence ESG (Environmental, Social and Governance) focused investing has taken-off in recent years. For example, this means that rather than simply tracking the S&P 500 with your money, you own a fund that owns the companies within the S&P 500 that have a more positive ESG impact. However, as academics dig into the criteria, they find that the ESG provider chosen can lead to very different investment choices.
Researchers including those at Harvard University in a paper titled, ‘Four Things No One Will Tell You About ESG Data’ have looked at how companies are scored on ESG criteria. The results aren’t encouraging. The same company can receive different ESG scores depending on the firm that’s assessing it. This can be due to data-gaps, benchmarking differences or simply differing interpretations.
For example, employee health and safety is generally considered an important criteria for ESG investors. However, the way it is disclosed and measured varies. For example, is it better to examine the number of fatal accidents or the rate of injury per 200,000 hours worked? There are tens of different ways to assess employee health and safety, but measurement differences can leave to differing assessments even for the same firm. This problem is compounded as different firms share different metrics.
The comparison set of firms matters too. For example, a mining company may look good when compared to other mining companies, implying a high ESG rating. But, if compared to all companies, it may perform poorly, implying a low ESG rating. Therefore the comparison set matters. For the same firm, comparing against a different set of companies can change its ESG score. Again, there is no uniform approach to this.
Finally, data gaps make a different too. If a company doesn’t report a particular piece of data there are various methodologies to fill the data gap. Do you give the average score? Do you interpret from the data you do have? Do you make assumptions based on historical disclosure? Again the method chosen can lead to quite different ESG scoring.
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Researchers at MIT and the University of Zurich recently came to a similar conclusion. Here the researchers took a more quantitative approach to looking at the differences in ESG scoring and found that differing definitions and scoping of categories accounted for most of the divergence in ESG rankings. They also found some subjectivity in how different firms were assessed too.
ESG continues to grow in importance for investors and company discloses are becoming more detailed. However, there is no single source of truth, the ESG benchmark providers you chose may impact your portfolio composition more than you think. Maybe this is a good thing as you can select the ESG methodology that better reflects your own values, but investors should be aware that there doesn’t appear to be a single ESG measurement standard currently.