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CUHK Business School Research Finds the Inconsistent ESG Scores from Different Rating Agencies Decreased Investor Demand for Green Stocks

 – 24 September 2021 – Sustainable investing, once viewed as an outlier maybe only
a decade ago, has never been more popular. To put things into perspective,
sustainable funds in the U.S. attracted record investment of nearly US$2
trillion in the first quarter of 2021, according to industry data provider Morningstar.
As demand for ESG (environmental, social and governance) investing grows, so
does the need for better quality ESG performance data. However, a recent
research study has found that ESG ratings of firms provided by different
agencies can be confusing to investors and may be holding back the sustainable
investment sector from realising its full potential.

It is not uncommon for the ratings of different ESG rating
providers to be widely dissimilar. For example, Tesla Inc. is rated average by
MSCI ESG ratings but categorised as high risk by Sustainalytics. (source:


Sustainable investing, also known as
ESG investing or socially responsible investing, is an approach that asks
investors to consider a company’s ESG profile alongside its financials when
making an investment decision. Such additional factors include everything from
a company’s energy use, waste and pollution, to its working conditions,
participation in its community and diversity in its board of directors. Because
of these considerations, it is not unusual for sustainability-minded investors
to set maximum thresholds or even shy away altogether from less “ethical”
sectors such as coal, defence, gaming or tobacco.


Perhaps due to its relatively recent
arrival in the finance world – the term ESG investing itself was first coined
by the U.N. Global Compact as
part of a landmark 2004 study titled Who Cares Wins, there is no universal standard nor a commonly accepted
methodology for calculating ESG ratings among different agencies. According to KPMG, there are
around 30 major ESG data providers worldwide in 2020. These rating agencies
usually adopt different measurements when constructing their ESG scores. It is
not uncommon for them to provide different ESG ratings for the same company.
For example, Tesla Inc. is rated average by MSCI ESG
ratings but categorised as high risk by


The new study Sustainable Investing with ESG Rating Uncertainty was co-conducted by Si
, Assistant Professor in the
Department of Finance at The Chinese University of Hong Kong (CUHK) Business
School, Prof. Doron Avramov at IDC Herzliya, Prof. Abraham Lioui at EDHEC
Business School and Prof. Andrea Tarelli at the Catholic University of Milan.


In their study, Prof. Cheng and her
co-authors tested their hypothesis using U.S. stocks from 2002 to 2019 and
examined the ratings from six major ESG rating providers – Asset4 (Refinitiv), MSCI
, MSCI IVA, Bloomberg, Sustainalytics and RobecoSAM.
In line with existing studies on ESG ratings, the research team also found
considerable disparity across different ESG rating providers. They found that
the confusion in the different ratings provided by the ESG rating agencies made
sustainable investing riskier and decreased investor demand for stocks.


Ratings Disagreement

“Generally, because there’s a
lack of consensus in reporting, measuring and interpreting ESG information,
there’s a lot of ESG data out there on firms and these can both be overwhelming
and perplexing. That’s why it can be difficult for investors to ferret out the ‘true
colour’ of a firm, whether that be, green, brown, or something in between,”
Prof. Cheng says. “That in turn feeds back into investor appetite in
sustainable investment. If an investor is looking for ESG plays and they’re not
clear about the sustainability of the stock they’re about to sink money into,
then they obviously are going to think twice before proceeding.”


Using data from the six ESG rating providers,
the researchers generated an ESG score for each stock, as well as a score to
measure the difference in the ESG scores between the six agencies in order to
calculate the level of uncertainty in ESG ratings. According to the results,
the average rating correlation is only 0.48, and the average ESG rating
uncertainty is 0.18. For perspective, this means that a company could be ranked
in the bottom third by one data provider but be ranked in the 59th percentile
by another.


Using these scores, the researchers
looked at how inconsistency in ESG ratings affected whether an institutional
owner would invest in a particular stock, and the impact on the stock’s actual
performance on the market. The study considered three distinct types of
investors. The first type are organisations such as pension funds as well as
university and foundation endowments, which constrain their investments to
socially acceptable norms (such as by engaging in socially responsible
investing) when compared with other institutional investors which are more
interested in generating financial returns, such as hedge funds.


The study found that institutions
which were more constrained by investment norms were indeed in favour of
greener firms, but were less likely to hold green stocks when there is a high
level of inconsistency over ESG ratings. For companies with the highest ESG
scores, norm-constrained institutions on average hold 22.8 percent of their
shares, but only when the ratings put out by the different ESG agencies were in
high agreement. When the correlation in ESG ratings between the different
ratings agencies were low, institutional ownership level dropped to 18.1


In contrast, hedge funds invest more
in brown stocks on average, and rating uncertainty mostly affects their
holdings for brown stocks. For companies with the lowest ESG scores in the
study, the researchers found that hedge funds owned an average of 15.7 percent
of shares when there was high agreement between the ESG scores from different
ratings agencies. This again dropped to 13 percent when the correlation in the
ratings from different agencies diverged. The authors conclude that rating
uncertainty matters the most for investors in their preferred investment


And while companies which focus on
improving their ESG performance are expected to deliver lower investment
returns because they provide nonpecuniary benefits to investors, the study
found that this was not always the case. Specifically, it found that brown
stocks always outperform green stocks only when ESG ratings ambivalence is low.
When there is a high level of agreement between the ratings of different ESG
rating agencies, brown stocks surpass green stocks by 0.59 percent per month in
absolute returns and 0.40 percent per month in risk-adjusted returns. But when
inconsistency between ESG ratings rises, there is no clear relation between a
company’s ESG leanings and their stock performance.


Market Implications

Lastly, the study implies that
ambiguity in ESG ratings has an overall impact on the entire stock market. In
particular, a higher level of ratings confusion is linked with higher market
premium, as well as lower stock market participation and lower economic welfare
for ESG-sensitive investors.


Green stocks are harmed the most
when ESG rating confusion is high. Firms which take a more responsible path in
their operations are disproportionately penalized if ratings agencies fail to
agree on their ESG profile. This in turn would further limit their ability to
make capital investment and generate a real social impact.


“In the face of uncertainty
over a company’s ESG profile, ESG-sensitive investors are just as likely to
stop making ESG investments or engage in corporate ESG matters,” Prof.
Cheng adds.


Overall, the study results have significant
implications for asset allocation, investor welfare, and asset pricing. In
order to minimise the downside brought to ESG investing by rating
inconsistency, Prof. Cheng and her co-authors suggest companies disclose more
candid reports on their ESG performance. For ESG rating providers, the
researchers advise them to further release and explain their measurement
practices and methodologies. Furthermore, they argue that more public
discussion on how to measure ESG performance of companies should help to
elevate the quality of ESG ratings.


“Sustainable investing is on
the rise. Therefore, the overall impact of ESG rating inconsistency will become
even more prominent,” Prof. Cheng says.



Avramov, Doron and Cheng, Si and Lioui, Abraham and
Tarelli, Andrea, Sustainable Investing with ESG Rating Uncertainty (July 26,
2021). Available at SSRN: https://ssrn.com/abstract=3711218 or https://dx.doi.org/10.2139/ssrn.3711218


This article was first published in the China
Business Knowledge (CBK) website by CUHK Business School: https://bit.ly/3kq2Y12.


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