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


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

Read the full report

0 pages | 3,866 kb

download

Important information

This communication is marketing material. The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

This document is intended to be for information purposes only and it 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. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy.

The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.

Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.  Exchange rate changes may cause the value of any overseas investments to rise or fall.

Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.

The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.

Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.