Scientific Beta

It is well known that ESG scores diverge widely across providers, putting their reliability into question. This papier examines whether ESG scores can be made to converge, but also achieve investors' impact goals, and improve risk management.

It is well known that ESG scores diverge widely across providers, putting their reliability into question. While this situation is often lamented, it would not be unreasonable to hope that if ESG rating agencies used common definitions for their outputs, and had more reliable inputs at their disposal, in the form of standardised, quantified and verified corporate ESG reporting, that this confusion could be overcome. That is indeed an aim of the EU’s Corporate Sustainability Reporting Directive and the forthcoming EU regulation of ESG rating agencies, which will increase transparency of scoring methodologies. Unfortunately, as we will see in the first part of this paper, recent academic research dashes such hopes.

Nevertheless, despite the divergence, investors might still hope they can use ESG scores to underpin impact investing  strategies. This is what we investigate in the second part of this paper. Again, recent academic findings cast doubt on such investor aspirations. One definition of impact investing is an investment strategy that incentivises investee companies to change their behaviour and products/services for the better, i.e. impact in the sense of changes to corporate activities. Here, the divergence of ESG scores dilutes any positive real-world impact investment strategies built on such scores might have, as investors fail to pull the right companies in the right direction. Instead, amid the fog, they pull different companies in different directions. A more down-to-earth definition of impact investing is to finance companies whose activities make a significant contribution to certain ESG goals (preferably with an additionality requirement, that the activity would not be carried out had the financing not occurred). In this perspective, recent research has shown that ESG scores can have negative impacts, as they rely heavily on lofty corporate promises, which serve as a smokescreen for current harmful corporate practices. And except for carbon emissions reduction targets, ESG promises are usually not realised by companies in the future either.

In the last part of this paper, we ask whether ESG scores can be more useful from the second perspective of double materiality: while ESG scores fail to correctly measure the impact of companies, perhaps they can still provide insights about impacts on companies? That is, can ESG scores bring useful insights into financial risks and hence be a relevant risk management tool? The Covid market crash did not provide a clearcut illustration of good ESG scores being a sign of resilience to external market shocks. But further research is still needed on the question of whether ESG scores – and especially their underlying metrics – may improve forecasts of idiosyncratic stock risks.