Bias in ESG ratings can lead to lack of compliance

13 November 2019

Bias in the methodology used in the way environmental, social and governance (ESG) ratings are approached means investors may not be getting the full commitment to those requirements.

Mike LaBella, head of global equity strategy at QS Investors, said ESG meant something different depending on who you talk to, which is not only true for investors but for the experts as well.

“There's almost no correlation amongst their ratings, one provider can think they are an extremely good ESG company and a different provider can think they're a horrible company,” LaBella said.

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The methodology used by ESG rating companies meant there were ways companies could present themselves as being ESG compliant without fulfilling those requirements.

This often led to a bias towards large-cap companies who could claim to be ESG compliant by having a policy in place, even if it wasn’t followed through effectively.

“When we talk about bias, we analyse the rating companies we use to see who’s reliant on survey data,” Labella said.

“The vast majority of rating houses relied on survey data to come up with their ratings by sending out questionnaires to companies.”

“Not surprisingly, the companies that would mark ‘yes’ were large-cap companies and ones that didn’t were small-mid cap companies.”

LaBella said just because a company had a policy in place, doesn’t mean they had been implementing it effectively.

“The case in point was Wells Fargo, who had a significant amount of governance troubles over the last couple of years, was a top-tier governance rated company,” LeBella said.

“It’s because it had an appropriate policy, but the fact is it hasn’t implemented those policies.”

It had now become a challenge for investors because managers could say they take ESG into consideration without being an ESG fund.

“What you’ll see is a great many funds that say they’re ESG don’t actually have that many good ESG companies they’re investing with,” LeBella said.

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