ESG rankings, greenwashing and the need for competent managers

The need for transparent and standardised information around companies’ sustainability profile, performance and risk exposure is a major challenge for the scaling up of sustainable investments. This has led to the creation of sustainability and environmental, social and governance (ESG) indices, which have, in turn, gained considerable importance in the market — even during the Covid-19 pandemic — moving from the niche to the mainstream. 

Measuring a firm’s sustainability is not a straightforward task. It comprises dimensions such as environmental impact, social engagement and good governance. Challenges in assessing these dimensions have deeper repercussions on the real economy, as millions in savings can be misdirected in the investment industry.

The term ‘ESG’ was officially introduced in 2004 by the UN Global Compact Initiative in its ‘Who cares wins’ report. In the past decade, growing concerns about global warming and the implications of the 2008 financial crisis have led to a significant increase in investor preferences for sustainable investment. ESG-related investment products have seen a significant increase in volume and are no longer a niche investment practice today. This market segment is likely to continue increasing, yet in a more orderly way, in the light of regulations, such as the European Commission’s EU sustainable finance agenda, the ‘Next Generation EU’ plan, and the EU Recovery and Resilience Facility, with at least 37% of funds dedicated to the transition to a greener economy.

Today, the majority of the world’s asset managers are signatories to the UN Principles for Responsible Investment, representing around $100tn in assets under management. However, investors, managers and policy-makers need a deeper understanding of the inherent peculiarities of this new and rapidly growing financial sector, which is not yet sufficiently or properly regulated. Moreover, the conditions for taming moral hazard and greenwashing need to be in place.  

Fuelled primarily by investor interest, the market for ESG data and ratings is developing quickly. In our paper ‘Inside the ESG ratings: (dis)agreement and performance’, we investigate the calculation methodology, the metrics used and the main differences among the numerous ESG rating agencies operating in the market today. We find that the lack of agreed definitions of what constitutes the ESG dimensions — and what does not — has led agencies to use different measurement approaches. As a result, the same company can have highly divergent ESG ratings depending on who has rated it. This has strong implications both on the operational side, for example on the identification of reliable benchmarks, and in terms of returns. Disagreement over the ESG ratings provided scatters the effect of investors’ ESG preferences on financial asset prices to the extent that even when there is general agreement, it has no impact on financial performance. 

In addition, following market demands, ESG rating agencies frequently find themselves forced to change their methodology, contributing further to the confusion. We highlight the effects of such methodology changes in another paper, ‘The salience of ESG ratings for stock pricing: evidence from (potentially) confused investors’. We show that changes in ESG ratings induced by changes in methodology (and not related to potential fundamental changes in the sustainability of the firm) exert a transitory pressure on stock prices. Our analysis shows that retail investors are particularly sensitive to changes in ESG ratings and divest from stocks they believe to be downgraded, moving to stocks with increased ratings. However, since these changes have no tangible economic basis, short-sellers act as arbitrageurs or informed investors and, by acting as counterparties to retail investors, literally gain from the confusion that ESG rating agencies create in the stock market.

Finally, disagreement and confusion easily open the door to greenwashing and make its detection more problematic.

Navigating such a heterogeneous and opaque market segment carries considerable risks — one of the major ones being misleading investors to an inefficient allocation of their resources. In this context, university education plays an important role. Starting with, but not limited to, courses in economics and finance, the ESG issues must be addressed with scientific rigour. Demand for ESG knowledge from the labour market is very high. Investors and banks advocate the integration of ESG criteria in the assessment of creditworthiness and in the evaluation of the related risks and opportunities. Therefore, increasing knowledge of sustainable finance issues among tomorrow’s managers is crucial.

Monica Billio is professor of econometrics at Ca’ Foscari University, Venice; Loriana Pelizzon is professor of economics at Ca’ Foscari University and head of the financial markets department at the Leibniz Institute SAFE.