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Exploring the complexities and nuances of ESG ratings

Much has been made of ESG ratings recently, from critiques across the U.S. political spectrum to The Economist advocating that ESG adoption should be dropped in favour of directly assessing environmental impacts or simply measuring CO2 emissions. Research from MIT Sloan’s Sustainability Initiative would suggest that there is ‘signal within the noise’ and that abandoning ESG altogether because of ratings challenges would be akin to ‘throwing the baby out with the bathwater.’

The methodology used by the researchers to examine ESG ratings is described as ‘regressing ESG ratings across one another, against stock returns’, with additional controls for external variables. This effectively compares ESG scores against financial returns, to determine if there is a relationship or ‘signal’ so to speak.

They find that there is a substantial degree of noise, at almost 60%, meaning that a sizable amount of the data is not meaningful or useful. However, this also suggests that ESG ratings have some signal to them. The researchers corrected for the noise and found a positive correlation between ESG scores and financial returns. It would seem that ESG scores provide some valuable measure of a range of factors, while also proving to be a function of financial returns.

The authors assert that some of the alternatives suggested, such as measuring CO2 output directly, are just as flawed, if not, more so, than current ESG methodologies. This is due to the implication that environmental concerns are the sole priority, at the expense of other genuine concerns such as labour practices, safety, and lobbying. ESG scores are computed using complex, multivariate analysis which is a more comprehensive measure of the negative externalities an organisation produces. This sophistication also means that ESG scoring is more costly than simply measuring CO2 output; however, ratings agencies can undertake and benefit from economies of scale and specialisation which drives long-run average costs down.

The quality of ESG data would benefit from changes from regulators, such as increased reporting requirements on methodologies and standardised disclosure, which the researchers hold would increase the reliability of scores. Another improvement ESG ratings would benefit from is the inclusion of sub scores (across a multitude of ESG criteria) which would benefit comparisons and benchmarking. While ESG is not perfect, the report calls for ‘redesign not resign’.

The complexities and vagaries involved in applying ESG data into faith investments speaks to the challenges faced by many faith-based asset owners, which we've outlined in our recent report, Faith-Consistent Investing and Smaller Organistations. We highlight the importance of using all available insights and data in making sound faith-consistent investments.


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