Rethinking ESG scores
The ESG investing industry has attracted trillions of dollars in part by telling investors they can “do well by doing good.”
Thousands of funds and other investment products have been created around the idea that identifying companies with rising scores on environmental, social, and governance (ESG) measures can lead to market-beating returns.
Yet a paper co-authored by Professor Panos N. Patatoukas and published in The Accounting Review suggests that outperformance attributed to improving ESG scores—as measured by current standards—may be a mirage.
“Sorting out correlation from causation is critical in the debate over ESG investing, and we found correlation, not causation,” Patatoukas says.
The researchers—who include Byung Hyun Ahn, PhD 21, of Dimensional Fund Advisors and George S. Skiadopoulos of London’s Queen Mary University—found that relatively larger, more stable, more profitable companies are more likely to have their ESG scores upgraded because they have the most resources to fix weaknesses in those scores and promote improvements. Any above-market returns attributed to ESG scores disappeared when Patatoukas controlled for revenue, growth potential, and other fundamental stock-screening factors.
“Trillions of dollars of capital have been allocated according to the idea that you can rely on improving ESG ratings to beat the market,” Patatoukas says. “Our data challenge this idea.”
His research does not suggest that companies should lessen efforts to reduce carbon footprints or relax plans to be better corporate citizens. Instead, those goals must accelerate in the face of the climate crisis, Patatoukas says.
To give investors the transparency to make decisions in line with their values, he believes the ESG measurement system needs a major overhaul to include information beyond what is already in corporate financial statements.
Patatoukas disagrees with the premise that more responsible portfolios need to necessarily outperform the market—the very idea of doing well by doing good. Investment outperformance is not necessarily an indication of environmental or social progress but rather a measure of capital transfer across investors, he says.
Efforts at greater transparency could falter if firms fail to accurately measure and disaggregate indicators that capture each of ESG’s individual performance dimensions, says Patatoukas. Creating a better measurement system will require a collaborative effort across finance, accounting, economics, operations, climate science, and software engineering. Meanwhile, companies will operate with a patchwork of laws and regulations for the near future, with the Securities and Exchange Commission’s long-awaited climate-disclosure rules blocked by litigation.
“The massive opportunity here is to go beyond identifying companies that are good at checking all ESG rating boxes and develop a way to measure those making real strides toward decarbonization,” Patatoukas says. “Better measurement will facilitate more efficient allocation of capital and speed transition to a more sustainable future.”