November 1, 2019

ESG Schizophrenia..........How To Cure It

“Schizophrenia is a mental illness characterized by abnormal behavior, strange speech, and a decreased ability to understand reality. Other symptoms may include false beliefs, unclear and confused thinking, and hearing voices that do not exist….”

 WIKIPEDIA

 

“Despite its follies, foibles, and fashions, the stock market is a good deal more rational than the ‘experts’ over any extended period of time.”

PETER DRUCKER

 

ESG Schizophrenia

The New York CFA Society recently surveyed a large sample of asset owners on their attitudes towards, and feelings about ESG. Forty five percent responded that their organization had fully, or significantly integrated ESG across their portfolios. Another 39% said they were on their way to doing so. At the same time, the respondents confessed to having an ESG worry list which included data quality problems, terminology confusion, political and regulatory uncertainty, greenwashing, and scepticism about the validity of the ESG concept itself.i    

A recent academic paper titled “Aggregate Confusion: The Divergence of ESG Ratings” provides empirical justification for the ESG worry list. Based on a detailed assessment of the ESG ratings from five different agencies, the authors found material divergences between the five rating sets due to what the paper called ‘scope divergence’, ‘measurement divergence’, and ‘rater effect’. Scope relates to decisions of what factors should be included in the definition of ESG, measurement relates to decisions on what metrics best represent each of these factors, and rater effect is the apparent tendency of some agencies to like and  dislike certain companies (i.e., represented by systematic upward and downward biases in how the components of the ESG rating were scored and assembled). The authors conclude that this diversity in ESG ratings leads to material diffusion of their impacts on asset pricing, on signals to corporations, and on research conclusions.ii

Where does all this leave asset owners? Are ESG ratings useful? Are some more useful than others? Do they help control investment risk? Enhance investment return? Both? Neither? These are the questions this Letter addresses.

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