Higher Divergence in ESG Ratings Leads to Higher Returns

A well-established problem facing investors with an environmental, social and governance (ESG) mandate is the wide divergence of ratings assigned to companies by different vendors. New research shows that those stocks with the greatest divergence had higher performance.

By the end of 2020, there was an estimated $35 trillion of assets (up from $23 trillion in 2016) managed under environmental, social and governance (ESG) principles – ESG investing has entered the mainstream of investing.1 While there are seven competing vendors providing ratings to measure how companies perform along ESG standards, those ratings differ widely across vendors.

My August 24, 2020, November 23, 2020 and June 20, 2021 articles for Advisor Perspectives presented evidence from research demonstrating that ESG investors face considerable challenges in allocating assets because the data used to construct ESG portfolios differ so widely among providers. The result is that there can be a wide disparity of ESG ratings for the same company.

Divergence in ratings

Divergence in ratings has three sources. Raters use different categories, which can lead to disagreement (referred to as “scope divergence”). Raters measure identical categories differently (“measurement divergence”). Third, raters attach different weights to the different categories (“weight divergence”) when generating an aggregated ESG rating. Florian Berg, Julian Kölbel and Roberto Rigobon, authors of the 2019 study, “Aggregate Confusion: The Divergence of ESG Ratings,” found that most of the divergence in ratings could be traced to measurement and scope divergence, while weight divergence seemed to play a minor role.

Because of the divergence in ratings, funds may not be aligned with investor objectives and beliefs. In addition, the return and risk of ESG funds can differ significantly and are driven by fund-specific criteria rather than by a homogeneous ESG factor. Further complicating matters is that Dane Christensen, George Serafeim and Anywhere Sikochi, authors of the 2021 study, “Why Is Corporate Virtue in the Eye of the Beholder? The Case of ESG Ratings,” published in The Accounting Review, found that greater firm ESG disclosure generally exacerbates ESG rating disagreement rather than resolving it.