Sustainable Investing: The Black Box of Environmental, Social and Governance (ESG) Ratings

Abstract

Environmental, social and governance (ESG) investing is becoming mainstream, and the COVID-19 pandemic has amplified the momentum. The interest in ESG investing has created greater demand for ESG data, ratings and rankings together with a proliferation of agencies offering these products which are unquestioningly relied on by investors, academics and regulators. Research highlights that different ESG ratings and rankings produce significantly different assessments of the ESG performance of companies. In this paper, we examine the causes of the differences in the ratings and ranking produced by different agencies. It is found that the divergences between raters can be attributed to differences in defining ESG constructs (i.e., theorisation problem) and methodological differences (i.e., commensurability problem). While users of ESG ratings and rankings are advised to study the definitions and methodologies prior to their use, lack of transparency about the data sources, weightings and methodologies makes it difficult to ensure that companies’ true ESG performance is accounted for when making portfolio selection and investment decisions. As a solution, we suggest that instead of attempting to compare and contrast ratings and rankings of different agencies, investors should determine ESG constructs material to their investment strategy and match them with an ESG ratings/rankings product that closely resemble those constructs.