ESG ratings may be working against the overall sustainability of business and may cause companies to “inflate” their ESG performance.

These findings come in a study by researchers at the University of Maastricht which looked at whether ESG ratings actually caused firms to exaggerate ESG performance in the hunt for better ratings.

The causal chain Dennis Bams and Bram van der Kroft find is this: investors seeking to invest in sustainable companies use ESG ratings because they have difficulty judging performance themselves. A fear investors will divest from their stock prompts companies to take measures to “inflate” their ESG performance, whether or not they are doing well on sustainability.

This in turn means ESG ratings feature companies that are “underperforming” compared to “conventional investing in sustainable performance”.

That causes companies that are actually doing well on sustainability, but perhaps not winning on ESG ratings, to face a higher cost of capital.

There’s more: since most information for ESG ratings is based on promising “future sustainability performance improvements”, many ratings, including some of the biggest, fail to capture “realised sustainable performance”.

Bams and van der Kroft conclude that they “fundamentally question the use of ESG ratings in both academia and practice”.

Promised vs realised performance

The pair looked at ESG scores of 7,232 companies between 2003 and 2020 based on metrics used by Refinitiv, MSCI IVA and FTSE ESG, some of the major ratings companies.

Through statistical analysis the researchers find that a company can actually experience an ESG controversy—for example polluting, or exhibiting poor labour and governance practices—while doing well on their ratings scores. “This indicates that ESG ratings are contemporaneously inflated on a large scale,” they conclude. If aggregated this could mean that business is not contributing to sustainability but, in fact, running against it.

The researchers also observe that an increase in ratings performance could decrease the cost of capital by as much as 24 basis points.

But why do this? Why make big promises on sustainability? The researchers say it is because companies fear investors will divest based on ESG ratings data. They therefore keep investors happy by inflating their ratings scores.

The answer they say is for investors to move away from ratings based on promised performance and use actual performance. “We recommend that socially conscious investors rely on realised sustainable performance measures to alleviate these societal concerns.”

ESG ratings and investors

The findings will add to the growing controversy surrounding the use of ESG principles to guide investment policy.
Current estimates put the value of sustainable funds at around $3.8trn, with most of that, $3.4trn, invested in Europe and only around $330bn in the US.

Bloomberg reports that after three years of astonishing growth, ESG investing has tailed off. Money into ESG funds shrank by 36% in the first quarter of 2022.

After much criticism of ESG investing as “greenwashing”, headlines have recently been dominated by news that German police are probing DWS, a German fund manager, and its owner Deutsche Bank in relation to ESG claims. The US financial watchdog, the Securities and Exchange Commission (SEC) is also currently investigating Goldman Sachs. The event caused some columnists to claim the SEC’s “war on greenwashing” has begun.

Some commentators speculate more investigations will follow, while others complain about the gap between public expectations of ESG funds and how they’re actually run. For example, in some cases investors can invest in an ESG fund only to find it may contain a fossil fuel company or one of the big tech companies. Definitions of ESG may vary significantly.
ESG has also been targeted by the right in US politics for being part of the “woke” liberal agenda.

Elsewhere the SEC is working on a new rule requiring more disclosures from investment houses that claim ESG drives their investment strategy.

In a very short time ESG has gone from being an investment and business buzzword, and potential aid to saving the planet, to contested concept. There may be grounds for that. Likewise there are strong grounds to argue the core of ESG is entirely correct but in need of refinement. Bams and van der Kroft’s paper will now become part of that argument.