Beware of ESG Ratings: My Cautionary Tale from the 2022 Inaugural Cornell ESG Conference

Beware of ESG Ratings: My Cautionary Tale from the 2022 Inaugural Cornell ESG Conference

Alicia Zhang, PhD Candidate in Earth & Environment at Boston University

In July 2022, I attended the inaugural ESG conference held at Cornell University. The conference highlighted the hopefulness and optimism surrounding ESG investments to foster a ‘green’ transition, but also emphasized concerns in the ESG practice due to systematic bias. ESG information may provide useful insights to investors on firms’ performances. However, it has long been understood that, due to its infancy, the current ESG practice has flaws and inconsistencies. The various and diverse methodologies used by rating firms, as well as the incompleteness of raw ESG data to construct ESG scores has drawn questions to the integrity of such scores by researchers and practitioners. The metrics and scores are currently challenging to trust and interpret, and some ESG practitioners are successfully misleading investors to construct a false narrative.

Many investors utilize ESG ratings constructed by ESG data providers like MSCI, Refinitiv (formerly ASSET4), and Sustainalytics, to quantify a firm’s performance in relation to ESG criteria. Yet, research has not yet come to a consensus on whether there is an impact of ESG ratings on investment returns. This is a tough spot for ESG rating providers to be in, especially since the ESG industry follows an ‘investor pay’ model in which ESG data vendors compete based on how useful their ratings are for ESG-related investment strategies. Given this model, ESG rating providers often want to demonstrate a positive relationship between high ESG scores and high returns, even if such a relationship does not exist.

A paper (voted the most outstanding paper by conference attendees) presented at the Cornell ESG conference by Dr. Florian Berg, a research associate at the MIT Sloan School of Management, highlights issues with ESG scores due to systematic biases in the ex-post restatements of Refinitiv data and how ESG funds can manipulate scores as well as raw granular data to give some firms a better ranking or classification. ESG metrics were adjusted upwards after the fact for companies that have superior financial performance, retroactively introducing a positive link between ESG scores and returns.  This was done without announcing the changes to the public; further data rewriting strengthened this relationship. The findings throw a cautionary caveat when using ESG ratings to make lofty aspirational statements with the goal of assuring shareholder profits. In effect, as the authors contend, this supposed positive relationship between Refinitiv ESG scores and returns on investments will draw in clients (and their money) to Refinitiv’s proprietary ESG score database, but also may mislead investors and their asset allocation decisions.

However, these findings should be taken with a grain of salt. Certainly, a major question is whether the restatement issue with Refinitiv data is applicable to other ESG rating providers, such as MSCI or Sustainalytics. This is a question that was brought up by the presentation’s discussant, Dr. Ryan Lewis, an Assistant Professor at University of Colorado Boulder’s Leeds School of Business. He assumes that there is pressure across rating providers to equate ‘green’ as ‘good,’ in terms of financial returns. Lewis also wonders how institutional investors respond to these restatements. Funds may be reallocated to firms that have a track record of being ‘green,’ i.e., have had ‘good’ ESG scores for a relatively long time. However, given that Refinitiv does not publicly disclose its restatements, I find it highly likely that investors and asset managers are unaware of the restatements and, by extension, their impacts on firms’ actual ESG performance. Further analyses on whether ESG data rewriting is occurring on a broader scale is necessary to understand what the impact of this bias is on decisions made by firms and ESG practitioners, as well as on academic research.

ESG rating providers are not the only actors that can mislead investors. Another paper presented by Dr. Filippos Papakonstantinou, a Reader in Finance at King’s College London, finds that mutual funds that discuss their ESG investment strategy in their prospectuses attract higher flows, especially if the prospectuses contain ESG-related ‘buzz’ words in their prospectuses, compared to prospectuses that contain information on fundamentals, such as disclosed fund holdings or realized fund returns (a finding that supports Lewis’ assumption). However, these buzzwords can mislead investors in terms of actual performance. ‘Greenwashing’ funds that represent their investment strategy in a manner that makes it appear as if they are more heavily tilted towards ESG than in reality attract flows similar to funds that are truthful about their commitment to ESG investing. Yet these funds perform worse than the funds that do follow through on their ESG commitments which, the authors argue, engender challenges for asset managers seeking firms that follow through on their ESG commitment and may hamper improvements in environmental and social outcomes.

These cases of mismanagement and successful manipulation of the ESG practice highlight the need for regulation and reorganization of the practice. As the two papers highlight, the traditional strive for optimal profits yields a system that may not produce actual environmental and social change, but instead continues to support the system in which public interests must step aside for private interests. To engender the change needed for a ‘green’ transition, incentives need to be put in place to better align private profit and social welfare. Further, outcome-based regulations, such as those proposed by the Securities and Exchange Commission (SEC), can improve the transparency of asset allocation and portfolio selection as well as can help investors make decisions that align with their own ESG goals.

The ESG practice is important and can work, but we must be wary of and address its flaws. In its current immature state, the ESG practice is vulnerable to exploitation and impacts investors’ asset allocation decisions. By being cautious of flaws within systems and working to fix them, we can improve the performance, sustainability, and resilience of a firm as the world moves towards a green and just economy.