Practical Applications of ESG Rating Divergence: Beauty Is in the Eye of the Beholder

Abstract

In ESG Rating Divergence: Beauty Is in the Eye of the Beholder, from the Winter 2021 issue of The Journal of Index Investing, Linda Zhang (of Purview Investments) examines why different ESG rating providers give different ratings to the same company or ETF. Investors rely on ESG ratings to make decisions, so ESG rating providers have significant influence over where investment capital goes. Investors need accurate ESG ratings so they can be confident they are investing in line with their objectives.

Zhang focuses on the three largest ESG rating providers: MSCI, S&P, and Morningstar. She finds that the firms give higher ratings to companies that publish more ESG data about themselves, thus putting smaller or newer companies at a disadvantage. Ratings diverge most on the social (S) and governance (G) components of ESG, which are less quantifiable than environmental (E) impacts. Divergence is widespread, with about a third of companies receiving ratings from different providers that diverge by 20% or more. The results suggest investors should check ESG ratings from more than one provider, and from providers not affiliated with the ETF industry. The ETF industry should consider creating standards to make the ratings process more transparent and objective.