A close look at ESG ratings


An analysis of sustainability assessments of Swiss large-cap companies over a period of five years has shown the challenges for companies and investors.

ESG (Environmental, Social, and Governance) ratings impact the companies under scrutiny as well as the investment firms that use those ratings, and few decision-makers do not have a strong opinion on whether these evaluations are useful. ESG ratings do have their strengths and weaknesses: they provide orientation by reducing a complex matter to only one figure or a few letters, but different rating systems can provide significantly different judgments about a company’s performance. That leaves investors questioning which ratings they can rely on. Likewise, listed companies have to balance the different views on their activities.

The sustainability consultancy valyt analyzed four ESG ratings for 20 large caps, mainly SMI-listed companies, over a period of five years in a study conducted for the Swiss investor magazine Finanz und Wirtschaft. A comparison of the companies’ MSCI ESG rating, Sustainalytics Rank, S&P Global ESG rank, and ISS Quality Score showed quite a significant divergence after normalization. However, a higher level of consensus was found for companies with normalized ESG ratings above five. Swiss Re, Zurich and Nestlé displayed the highest levels of agreement from 2016 to 2020, and Roche, Geberit and Richemont the lowest. In some cases, two ratings came to almost the same conclusion.

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The question of whether the 20 companies improved over time was answered inconsistently. Only three firms—Novartis, Partners Group, and Swiss Life—advanced in every rating. Some of the remaining 17 had already reached the peak and could not improve further. Around one third displayed a positive aggregated ESG trend, another third a very positive trend, and the remaining third a worsening ESG trend.

The correlations between two ratings did not exceed a value of 0.58, which is moderate. And yet, a research project by MIT and the University of Zurich came to similar conclusions two years ago, with correlations between 0.42 to 0.73 albeit in a different setting regarding time period, companies, and ratings. Florian Berg, Julian Kölbel, and Roberto Rigobon referred to measurement divergence (where rating agencies measure the same attribute using different indicators) as the main explanation.

The discussion about the relationship between ESG ratings, risk, and return is intense. There is a certain consensus that a good ESG rating can provide some protection against substantial downturns in stock prices. Some studies have focused on ESG momentum: a positive stock price reaction after an ESG rating upgrade. Others have seen strong ESG performance as an explanation for stock price returns . Still, the attribution of cause and effect should be handled with care. The more investors base their choices on ESG rating performance, the more such ratings will be able to drive stock prices.

The exclusion of certain stocks with low ESG ratings comes at the price of increased diversifiable risk. One empirical proof was presented by the University of Zurich in early 2021. Marco Ceccarelli, Stefano Ramelli, and Alexander Wagner analyzed funds with Morningstar’s “Low Carbon” designation. The researchers showed that Morningstar’s ESG rating “Globes” did not address climate risks but did limit diversification to a lesser extent than the “Low Carbon” designation.

Another important aspect in the review of ESG ratings is that they do not necessarily provide information about the impact of a company’s activities. This issue was addressed in a 2020 working paper from Harvard Business School that found the ratings instead tried to assess how companies deal with chances and risks. For instance, the absence or presence of diversity and inclusion policies is assessed in ESG ratings, but the question of how these policies are implemented is not.

The future role of ESG ratings as other methods and approaches are developed is an intriguing question. In addition, the potential of raw ESG data is largely untapped. The signaling effect of ESG ratings for the stock market, in comparison to buy recommendations or to sales and earnings surprises, remains an area of interest. Studies over longer timeframes should provide answers. In the meantime, it is helpful to understand what ESG ratings can tell us, and what they cannot.

A first version of this text was published in the Swiss investor magazine Finanz und Wirtschaft on April 2, 2021

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