By LARRY SWEDROE
While environmental, social and governance (ESG) objectives are increasingly becoming a primary focus in asset management, investors often confront a substantial amount of uncertainty about the true ESG profile of a firm. Demonstrating the point, the authors of the study Aggregate Confusion: The Divergence of ESG Ratings found that the correlations of the seven major providers of ESG ratings (CDP, Trucost, MSCI, Sustainalytics, Thomson Reuters, Bloomberg and ISS) averaged only about 0.6 (where 1.0 is perfect correlation and 0.0 is no correlation at all), and companies can receive dramatically divergent rankings on any one factor. As one example from my book, co-authored with Sam Adams, Your Essential Guide to Sustainable Investing, on the environmental factor, Facebook had a 1st percentile ranking by Sustainalytics and a 96th percentile ranking by MSCI. Such wide divergences in ratings are a result of the lack of consensus on the scope and measurement of ESG performance. For example:
1. There is a variety and inconsistency of the metrics that purport to measure much the same thing. The diversity of measure gives rise to considerable dissimilarity in ratings, reflecting firm-specific attributes, differing terminologies and units of measurement.
2. There are differences in how raters define the benchmark for comparisons. For example, Sustainalytics compares companies to constituents of a broad market index, whereas S&P compares companies to industry peers (a best-in-class approach).
3. At the company level, ESG ratings are plagued by missing data. When a company does not reveal metrics, some raters assume the worst and assign a score of zero. Others impute a score that reflects peers that do report the data. More sophisticated approaches use statistical models to estimate missing metrics but are often unclear about why a company gets a low or high rating.
4. Reflecting the lack of consensus on metrics, there is great scope for raters to disagree about the scores for particular companies.
5. Weighting schemes (the relative importance raters put on different metrics) vary greatly.
The result of the differences is that investors cannot reliably observe a firm’s true ESG profile and are thus exposed to uncertainty in their sustainable investment, begging the question:
How does all the uncertainty about ESG ratings impact asset pricing?
Doron Avramov, Si Cheng, Abraham Lioui and Andrea Tarelli sought to answer that question in their study Sustainable Investing with ESG Rating Uncertainty, published in the August 2022 issue of the Journal of Financial Economics, in which they analyzed the asset pricing and portfolio implications of uncertainty about a company’sESG profile.
They began by noting that an investor who extracts non-pecuniary benefits from holding green stocks is willing to compromise on a lower risk premium relative to an ESG-indifferent agent. They also explained that if investors learn that the market ESG score is higher than previously thought, the price they would be willing to pay for the market will be revised upward, while a downward price revision applies for a score lower than previously thought — in the presence of ESG uncertainty, a brown-averse agent could substantially reduce stock investing even when the market is green, on average.
Using U.S. common stocks from 2002 to 2019, they collected ESG ratings from six major rating agencies: Asset4 (Refinitiv), MSCI KLD, MSCI IVA, Bloomberg, Sustainalytics and RobecoSAM. They then employed the average (standard deviation) of ESG ratings across rating agencies to proxy for the firm-level ESG rating (ESG uncertainty) and sorted stocks into quintile portfolios based on their ESG uncertainty. They relied on institutional ownership as a proxy for the demand for ESG investment because research has documented that institutional investors do incorporate ESG when forming their portfolios. And while retail investors could still have ESG preference, it is highly costly to obtain and analyse the data. They considered three distinct groups: norm-constrained institutions, hedge funds and other institutions. Following is a summary of their findings:
Consistent with prior research, they confirmed that there are substantial variations across different rating providers — the average rating correlation was 0.48. The variations were quite persistent throughout the entire sample period.
Norm-constrained institutions, such as pension funds as well as university and foundation endowments, are more likely to make socially responsible investments compared to hedge funds or mutual funds that are natural arbitrageurs — norm-constrained investors display preferences for greener firms. For example, they held 17.7 percent of the brown stocks (those in the bottom ESG rating quintile), while they held 23.0 percent of the green stocks (those in the top ESG rating quintile), a 30 percent increase.
The ownership gap between low- and high-ESG rating portfolios attenuates when rating uncertainty increases. When uncertainty was low, green stocks displayed 5.8 percent higher institutional ownership than brown stocks, while the ownership gap declined to an insignificant 0.2 percent when rating uncertainty was high. This pattern was due to a decline in the demand for green firms when ESG uncertainty was high, and the difference was statistically significant and economically meaningful—even with growing ESG awareness, demand for green assets continued to diminish with rating uncertainty.
In the presence of uncertainty about the ESG profile, ESG-sensitive investors lower their overall demand for risky assets — the demand for equities falls due to ESG uncertainty.
While hedge funds invest more in low-ESG stocks (they held 15.7 percent of the brown stocks but just 12.7 percent of the green stocks), the ownership gap between low- and high-ESG rating portfolios tends to diminish as ESG rating uncertainty rises. For high-uncertainty stocks, the ownership gap was no longer significant — uncertainty plays a similar role in discouraging stock investment.
There was no strong ESG preference among other non-hedge fund investment companies, which are not norm constrained.
While the higher risk due to ESG uncertainty commands a higher market premium, there is an offsetting force when the market is green because ESG investors extract non-pecuniary benefits from holding green stocks.
The ESG rating was negatively associated with future performance among stocks with ESG uncertainty — brown stocks outperformed green stocks by 0.59 percent per month in raw return and 0.40 percent per month in CAPM-adjusted return; 0.46 percent per month in Carhart four-factor (beta, size, value and momentum) adjusted return; and 0.50 percent per month in Fama-French six-factor (adding investment and profitability) adjusted return. However, the negative return predictability of ESG ratings did not hold for the high-ESG uncertainty firms — these firms did not reliably display lower returns.
They also found that their results were stronger in the pre-2011 period because the conflicting forces of increased demand for green stocks drove up their relative valuations, producing capital gains in the short term. However, they noted that this “should not be interpreted as ESG rating uncertainty no longer matters in the future. Instead, the equilibrium outcome over longer horizons could be even stronger than the full sample evidence we document, due to the unexpected outcomes realized over the last decade.”
Their findings led Avramov, Cheng, Lioui and Tarelli to conclude “that ESG ratings are negatively associated with future performance when there is little uncertainty and that the ESG-performance relationship could be insignificant or positive when uncertainty increases.
Thus, the sin premium and carbon premium could be attributed to the notion that sin stocks (i.e., companies involved in producing alcohol, tobacco, and gambling) and carbon emissions are clearly defined and thus subject to minimal uncertainty among investors. On the other hand, other ESG profiles could be more challenging to measure or rely on non-standardised information and methodologies, thereby displaying more uncertainty and mixed evidence on return predictability.” They added: “Our findings imply that the lack of consistency across ESG rating agencies makes sustainable investing riskier and hence reduces investor participation and potentially hurts economic welfare. This has important normative implications. For instance, it would be useful for policymakers to establish a clear taxonomy of ESG performance and unified disclosure standards for sustainability reporting. It would be especially instructive to identify which investments are really green. Doing so could mitigate ESG uncertainty, thus reducing the cost of equity capital for green firms, leading to higher social impact.”
Investor takeaways
The negative premium predictability of ESG ratings is a result of the non-pecuniary benefits investors receive for being able to express their values. The changing cost of equity capital due to ESG preferences has important implications for economic welfare and social impact.
Given the presence of rating uncertainty, investors are less likely to make ESG investments and actively engage in corporate ESG issues, leading to an increase in the cost of capital for green firms, limiting their capacity to make socially responsible investments. This highlights the importance of reducing ESG uncertainty by increasing the consistency and transparency of ratings and establishing uniform disclosure standards.
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