Consensus remains elusive over the value of aggregated ESG metrics such as ratings and other scores despite a flurry of recent studies on the contentious issue.
Three issuers of ratings and indexes conducted their own research into the performance of funds and assets relative to their ratings and while two found at least some correlation between positive ESG metrics and returns, the third was more ambiguous.
In the positive camp, Bloomberg said that investors who had used its Bloomberg ESG Scores in their decision making had seen higher returns.
“We see evidence of outperformance resulting from the use of the Bloomberg ESG Scores to construct portfolios,” concluded the Bloomberg study’s authors Zarvan Khambatta, head of sustainable investments quantitative research, and Michael Zhang and Didier Darricau, senior sustainable investments quantitative researchers.
A Morningstar Sustainalytics study similarly concluded that low ESG risk scores had a “positive yet modest effect on stock excess returns”, or alpha, during times of market stress.
Factoring ESG risk into investment decision-making “supports the alignment of sustainability goals with effective risk management, while also contributing to the preservation of financial performance,” analysts Bin Dong and Kasey Vosburg stated.
However, research by index provider Scientific Beta concluded that integrating ESG metrics into portfolio calculations had some benefits for investors, but that any value disappears under different analyses.
“Our results show that ESG information allows to increase performance in traditional backtests but adds no value to portfolio construction when assessed in out-of-sample tests,” its authors noted.
Political Backlash
The reports come as debate continues to rage over the utility of aggregated metrics, especially at a time when the ESG movement is undergoing a political backlash.
Ratings and scores were introduced to give investors a simple indication of the sustainability of an asset, fund or company. Many were rushed to market as demand for ESG-focussed investments soared from a near standing start over the past decade.
Since, however, they have been criticised by some as opaque “black boxes” whose hidden methodologies invite suspicion. Some commentators have even suggested they are responsible for greenwashing, arguing that a single score cannot accurately reflect something as nuanced and complex as sustainability. One argument is that errant companies can gain an easy pass if their failure in one eco-critical measurement can be obscured in the final score by a strong performance in a non-critical gauge.
“Are ESG rating schemes truly capturing the real impact companies and institutions are having on the world or are they simply offering a convenient way to look responsible without being held accountable?” asked Deloitte India ESG Consultant Karanbir Singh in an essay posted on LinkedIn.
Weaker Regulations
The emergence of regulations covering ESG reporting had been hoped to bring some standardisation to the ratings and scoring industry. But the onset of the ESG backlash has been accompanied by a retrenchment of rules, potentially stymying the release of data critical to financial institutions’ decision-making processes.
The European Union, for instance, proposes to lessen the severity of ESG reporting obligations placed upon companies, with implications for capital markets participants.
Under the so-called Omnibus’ proposal earlier this year, the Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive (CDDD) could be trimmed to make disclosures less onerous on companies.
Investor associations with a total of almost US$7 trillion in assets told the European Commission weaker regulations reduce the amount of data they need to make meaningful decisions. Concerned market participants, including the European Sustainable Investment Forum of investors, index providers and ESG analytics firms, warned it is “likely to severely hinder the availability of comparable ESG data, which investors need to scale up investment for industrial decarbonisation and sustainable growth”.
More Data
The importance of data in the effective assessment of portfolios is made explicit in the Bloomberg report, which concluded that the correlation seen between the use of Bloomberg ESG Scores and outperformance is stronger when “informed by higher levels of quantitative data disclosure”.
The study looked at use of its Bloomberg World Large & Mid Cap Index and Bloomberg World Large, Mid & Small Cap Index. The authors said that the excess returns seen among investors that considered these gauges “are not entirely accounted for by exposure to known risk factors, such as country, industry or styles (e.g., value, quality), and could point to the scores containing information that is not captured by traditional factor models”.
While the report cautioned that the “overall evidence is mixed and warrants further analysis”, the authors said: “Investors, whether explicitly focused on ESG criteria or not, may benefit from studying and incorporating these signals into their investment processes.”
In the Morningstar Sustainalytics study, the authors created five portfolio benchmarks of progressively higher levels of ESG risk. They found that when tested against five risk scenarios that emerged between 2019 and April the year – a period that encompassed the COVID outbreak, the Russia-Ukraine war and the Trump tariffs – the gauge with the second-lowest ESG risk rating earned higher returns than the rest.
The report concluded that it would be beneficial for investors to take a “target-based, benchmark-driven investment approach that systematically incorporates ESG risk categories into portfolio construction”.
The Scientific Beta research tested 222 ESG metrics and data from news sources and documents against portfolios. The researchers found that there was an apparent advantage to using the scores versus using financial data alone. However, that difference disappeared when they were again tested to account for estimation risks.
They concluded that “despite the explosion of ESG data, more information does not mean better portfolios”.
Investments Grow
With ESG grabbing fewer headlines, the debate over ratings and scores may seem academic but no matter the sound bites from anti-sustainability politicians and the highly publicised retreat of some large companies from initiatives such as diversity, equity and inclusivity (DEI), billions of investor dollars are still being allocated to environmental, social and governance investments.
A report by sustainability investment provider EcoVadis found that 79 per cent of 400 corporate executives surveyed said they have continued to pursue ESG-focussed objectives. A third said they had reduced their public communications about such activities, an act of so-called “greenhushing” to avoid censure from critics.
Additionally Barnett Waddingham, a consultancy, said defined contribution pension schemes in the UK had increased by more than a third investments in funds with climate targets. And while Bloomberg’s estimate of the amount of capital locked into ESG-linked assets has been lowered in the wake of the backlash, it still estimates that the total passed US$30 trillion in 2022 and is on course to reach $40tn by 2030.
Deloitte India’s Singh notes in his essay that many companies have shown that they can have an impact on the environment by acting in a targeted way and that ratings should reflect that. Their methodologies, he said, should be revealed for all to see; they should be standardised and verified; the people most affected by decisions made according to ratings – workers, farmers, villagers and so on – should be consulted on the calculations; and, most importantly, they should measure actual impacts, such as reductions in pollution or water usage.
“ESG can become more than just a label,” he wrote. “It can become a real tool for change helping companies do good, not just look good.”
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