In IR Magazine's "Hermes: Industry ESG scores for small and mid-cap companies can be misleading," Hermes Investment Management fund manager Hamish Galpin imparts the asset manager's views on the significant shortcomings of ESG ratings and their outsized adverse impact on smaller companies, and advises investors who are seeking to meaningfully integrate ESG into their analysis to engage with companies in lieu of relying on these ratings.
He elaborates:
Researchers have identified four key failings of ESG ratings, which are amplified when applied to smaller companies:
- Market cap bias – Companies with more communication resources tend to score better
- Disclosure/geographic bias – National regulatory disclosure requirements drive scores, and scores reward disclosure (not necessarily performance)
- Industry bias – Ratings do not discern between very different business models in the same industry, with more mature and regulated industries generally scoring higher
- Reactivity – Ratings are dragged down for an extended period of time following a controversy, despite the high likelihood that the companies responsible have consequently implemented changes that could improve their performance relative to peers.
Among other thought-worthy insights, Galpin shares an example of a "high-quality" portfolio company whose ESG rating alone would indicate otherwise. Fortunately, Hermes looked beyond the ratings and learned via its engagements with the company that the subpar rating reflects (and is expected to continue to reflect for some time) partially informed and uninformed ESG data.
See also last week's report: "ESG Ratings are in the Eye of the Beholder," and additional ESG Ratings/Raters resources on our Sustainability/ESG page. This post first appeared in the weekly Society Alert!