Investors are unable to properly assess companies' performance on environmental, social and governance criteria and pinpoint material risks because of a lack of standardized data, a factor that may hinder the growth of ESG investing, according to the authors of a new report and market participants.
As a result, there needs to be a common standard for ESG definitions, and policymakers and regulators may need to make them mandatory, they said.
ESG has been taking on increasing importance in investment policies as investors weigh the potential financial risks of companies not taking into account factors such as climate change, diversity and executive compensation. According to the Organization for Economic Cooperation and Development, or OECD, sustainable investing accounted for $30 trillion in assets under management in Australia and New Zealand, Canada, Europe, Japan and the U.S. at the end of 2019, an increase of 30% from 2016. There has been an increased emphasis on the ESG movement with the outbreak of the coronavirus pandemic.
Confusion
The growth of the market has led to an increase in ESG data and rating providers, but that has only added to confusion in the market, experts said.
"Despite the proliferation of ESG data and tools, ESG performance is still difficult when trying to compare between companies, projects and financial products, and users are still getting a fragmented and inconsistent view of ESG," Angel Gurría, secretary-general of the Paris-based OECD, told a conference on the findings of an OECD report that seeks to address the issue.
"Such conditions make it difficult for the private sector to move toward the long term and to support greater sustainability and resilience coming out of the pandemic," he said.
An analysis by the organization based on Refinitiv data noted that 25% of U.S. companies have an ESG score, compared to 10% in Europe and worldwide, and just over 5% in Japan, the report noted.
The market capitalization of companies with ESG scores represents 78% of the total global market capitalization, representing around 95% in the U.S., 89% in the EU and 78% in Japan, showing that investors are using ESG scores for rating large companies, Greg Medcraft, OECD director for financial and enterprise affairs, told the conference.
Data differences
The OECD analysis assessed different ratings providers such as Bloomberg, MSCI and Refinitiv and showed significant differences between ESG scores and ratings for the same company.
"While there is a wealth of ESG data out there, it is not consistently comparable or easily verifiable," Medcraft said. There are different methodologies, metrics, weightings and subjective judgement in ESG ratings, making it difficult for investors to rely on that information to make investment decisions, he said.
For some, high environmental scores correlated with higher emissions, Medcraft said.
"This suggests that ESG practices are not supporting enhanced consideration of material risks," he said. "It makes it hard for fiduciaries to explain and justify decisions they make that are informed by ESG considerations, so it's a very significant factor."
There is also little evidence that strong ESG ratings are linked to outperformance, he said.
ESG scores exist because the data itself is very hard to interpret, not just because of underdeveloped corporate disclosure, but also because the data covers a "vast landscape" of disparate information, Linda-Eling Lee, managing director and head of global ESG research at MSCI, told the conference.
Some data assess a company's exposure to water shortages, while some can be company-specific, such as which directors bring expertise to a board, she said.
ESG ratings have been compared to credit ratings, but they are in fact very different as they are not trying to capture default risks, Lee said. Some ESG scores are simply trying to aggregate the ESG information available about a company for investors, while some try to capture something more specific by using underlying models, she said.
Some ESG ratings have been more effective at capturing financial risk and performance, and investors need to analyze how ESG ratings relate to risk, she said.
MSCI has gone back through 13 years' worth of data to see how long it takes ESG issues to feed through to stock market performance and how the weighting of the E, the S and the G in a rating contribute to assessing risk and performance, she said.
Greater transparency about what is financially material needs to be based on quantitative evidence, she added.
Common standards
Aerdt Houben, director of financial markets at the Dutch central bank and chair of the OECD Committee on Financial Markets, told the conference that methodologies had to be more transparent, but that companies often claimed intellectual property rights on the data, and policymakers may need to take action. Issuers should be rated on their ESG credentials, rather than just financial instruments being rated, he added.
The EU plans to address the issue of data in ESG ratings in the revision of its nonfinancial reporting directive, Alain Deckers, head of corporate reporting, audit and credit rating agencies at the European Commission's Directorate-General for Financial Stability, Financial Services and Capital Markets Union, told the conference.
But he also said there needs to be some kind of common standard.
"I don't see how we are going to crack this nut without moving to the use of common standards in some shape or form," he said.
There are, however, challenges to that because different jurisdictions are further ahead than others, plus there are already a plethora of different ESG frameworks, he said.