When it comes to choosing a university or buying a car, comparative ratings can help us make better decisions. But what happens when rankings diverge - or worse, contradict one another? Should they be disregarded, or can they still deliver valuable information?
It’s not just a question for university aspirants or car buyers. In the financial world, ratings divergence is a topic of intense debate, especially when it comes to environmental, social and governance (ESG) evaluation. Some critics have cited the divergence of sustainability ratings as part of an argument that ESG investing as an integrated strategy should be jettisoned altogether. “Deeply flawed” was how a recent cover story in The Economist summarised it. As a solution, it recommended a narrow approach focussing on only explicitly quantifiable metrics like emissions.
Meaningful impact requires more than one metric
But a narrow approach risks throwing out the baby with the bathwater. At worst, it would abandon meaningful improvements in other areas; at best, it makes perfection the enemy of progress.
Take the challenge of ESG ratings divergence. For starters, the comparison with credit ratings is inappropriate. Credit ratings try to assess one main parameter - probability of default - whereas ESG ratings take into consideration a multitude of factors in deriving a final rating. The more appropriate comparison for ESG ratings is with something like US university rankings - where ratings providers use multiple factors such as graduation rates, faculty resources, surveys, etc. The rankings that result continue to be debated intensely; ESG ratings will be no different.
Why do ESG ratings diverge?
One recent study by researchers at the Massachusetts Institute of Technology (MIT) found that correlations among ESG ratings ranged from 0.38 to 0.71. That’s a lot of room for divergence. But there are good reasons for this, given the current state of ESG investing:
- Providers apply different views as to which factors have material impacts on E, S or G factors, and at different weights
- The broad number of data points used - which also includes proprietary data sets and estimates employing AI tools
- Whether ratings are applied on a relative basis within a given sector or on an absolute basis across the coverage universe
The good side of ratings divergence: The case for diversity
Several global regulators and organisations have studied the issue of ESG ratings divergence, and while acknowledging challenges, their conclusions also highlight some distinct pluses to current approaches. Papers published by groups including the International Organization of Securities Commissions (IOSCO), Financial Markets Standards Board (FMSB) and International Regulatory Strategy Group (IRSG) broadly agree that a diversity of views, independent methodologies, subjective judgement, innovation, and competition can be beneficial to markets and investors. They however caution against mechanistic approaches characterised by over-reliance on ESG ratings. And if there is one common, overarching goal, it is data standardisation.
Simplification to isolate ESG factors isn’t so simple (for now)
Simplification has undeniable benefits, but even this data-driven approach may not be as straightforward as it appears. Consider these challenges to quantifying emissions: While over 13,000 companies participate in surveys by CDP, an NGO that measures environmental footprints, data on scope 1 (direct) and scope 2 (indirect) emissions is still quite scant. According to MSCI, scope 1 & 2 disclosure rates were below 40 per cent for MSCI ACWI constituents, while Scope 3 disclosure rates (emissions up and down the value chain) were below 25 per cent.
Attempts to address the problem of incomplete data can in many cases lead to more - not less - ratings divergence. Emissions data vendors try and bridge this data gap via varied techniques, including using estimates and alternative sources, their own proprietary tools, and targets announced by companies.
Narrow focus comes with significant risks
A narrow focus risks missing a key point: a company’s governance and conduct in society are also critical to ensuring it delivers on its intended goal in other areas, including emissions. We have long argued that any company that ignores stakeholders is bound to get tripped up at some point. Profit maximisation sought by companies such as Purdue Pharma was unsustainable given the significant harm to customers and communities as its products helped fuel the US opioid epidemic. Electric truck maker Nikola, whose stock price has plunged since its now departed founder was investigated for making false and misleading statements, is another cautionary tale.
No substitute for hard work
In time, industry and regulatory efforts to standardise the spectrum of ESG data and improve disclosures will help make ratings more comparable, and perhaps correlations will increase as a result. Until then, market participants will need to do their homework to understand the process that underpins a given ESG rating or even better, develop a robust proprietary method for ESG ratings. At the same time, investors should appreciate that divergence in ESG ratings also signals a diversity of views - and that’s never a bad thing.
Important Information
This document is for Investment Professionals only and should not be relied on by private investors.
This document is provided for information purposes only and is intended only for the person or entity to which it is sent. It must not be reproduced or circulated to any other party without prior permission of Fidelity.
This document does not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities in any jurisdiction or country where such distribution or offer is not authorised or would be contrary to local laws or regulations. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties.
This communication is not directed at, and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers.
Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International.
Past performance is not a reliable indicator of future results.
This document may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content.
Fidelity International refers to the group of companies which form the global investment management organization that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances.
Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German Institutional clients issued by FIL (Luxembourg) S.A., 2a, rue Albert Borschette BP 2174 L-1021 Luxembourg.
In Hong Kong, this document is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, Independently operated by FIL Securities (Taiwan ) Limited, 11F, 68 Zhongxiao East Road., Section 5, Xinyi Dist., Taipei City, Taiwan 11065, R.O.C Customer Service Number: 0800-00-9911#2 .
Brunei, Indonesia, Malaysia, Philippines and Thailand: For information purposes only. Neither FIL Limited nor any member within the Fidelity Group is licensed to carry out fund management activities in Brunei, Indonesia, Malaysia, Thailand and Philippines.
Issued in Australia by Fidelity Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). This material has not been prepared specifically for Australian investors and may contain information which is not prepared in accordance with Australian law.
ED22 - 183