"As the integration of ESG factors into investment decision-making becomes increasingly mainstream, over-reliance on simple answers and third-party industry data" could "give rise to a misleading picture," especially for smaller and mid-cap companies, according to a global investor. Hamish Galpin, Head of the Small and Mid-Cap Team at Hermes Investment Management, explained in IR Magazine that significant gaps in ESG disclosure levels among industries and companies indicate a need for more proactive engagement between investors and boards, reflecting similar concerns that have been expressed by large cap companies. Noting that "off-the-shelf ratings are often constructed without analysts forming a fundamental understanding of businesses or specialist industries," Mr. Galpin stresses the importance of direct contact with management rather than relying solely on third-party rankings.
The article echoes 2018 research by the American Council for Capital Formation that warned of biases within the ESG ranking industry, including biases based on company industry, geography, and size, not to mention the risks of lack of standardization and inconsistencies between ratings agencies. Mr. Galpin's article further notes that ratings tend to be "dragged down" for a long period of time following a controversy, whether or not this is supported by the company's responsiveness and pay for performance alignment.
Although the IR Magazine article focuses mostly on the risks pertaining to the use of ESG ratings for smaller or mid-cap companies, it highlights the proliferation of third-party ranking systems for a variety of ESG metrics (including, as the Center has previously reported, pay equity rankings) and how over-reliance on such rankings can lead to a distorted or misleading picture of company practice. Third-party rankings, while potentially useful in their own right, are no substitute for direct communication and engagement between investors and management when it comes to identifying ESG risk.