Economics

Managing corporate controversies: the role of environmental, social and governance (ESG) ratings

We explain why ESG integration is not just about managing downside controversy risks but the insight it can bring to future growth.

18 July 2017

Alexander Monk

Sustainable Investment Analyst

High profile corporate controversies are regularly used to highlight the value of ESG analysis.

Volkswagen’s emissions scandal, Enron’s fraud and BP’s Deepwater Horizon oil spill each appear to provide tantalising examples of the significant losses that could potentially have been avoided through a better understanding of company practices.

Our analysis suggests investors hoping conventional ESG ratings will help to identify these problems before they break are likely to be disappointed (Figure.1):

ESG ratings have shown no clear predictive value

Better-rated companies appear slightly more likely to experience controversies than worse-rated companies. This suggests that tick-box indicators of company sustainability are ineffective measures of controversy risk.

ESG ratings have reacted to controversies

On average, ratings have fallen by a full rating notch in the few months after a controversy becomes public. Most ratings include corporate controversies in their calculations, and while this mitigates the reputational risk of having high ratings for challenged companies, it disguises their limited predictive power.

Past controversies are a bad guide to future controversies

We find no meaningful relationship between the number of controversies a company has faced and the likelihood it suffers a future controversy. Ratings that rely heavily on past controversies therefore risk undermining their own effectiveness.

One of many inputs

This does not mean third party ESG ratings have no value. Instead it underlines the importance of understanding what they are and how they should be used.

We use information from several external ESG research firms, but only ever as one input into our own company assessments to be questioned, examined and built on.

We outlined our concerns about the use of ESG ratings to assess portfolio sustainability in ‘Painting between the lines‘ (Q3 2016).

The conclusions here expand on some of these concerns: principally that ESG ratings flatter investors who sell stocks after controversies emerge and penalise those who invest the time to evaluate each situation and buy shares when they conclude risks are overblown.

The value of ESG integration

To us, effective ESG integration means examining a company’s ESG performance and incorporating that analysis into investment decisions rather than outsourcing that analysis to third parties.

Moreover, effective ESG integration is not just about preventing large downside controversy risks. Rather, the key value of examining business model sustainability lies with the insight it can bring to future growth.

MSCI Company ratings

Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.