The financial landscape has changed significantly in recent years, driven by investors seeking meaning in their investments, on the one hand, and tighter regulation, on the other. Many reforms in the form of European directives and regulations concern the adequacy of information provided to investors in order to support the inflow of capital to projects that ensure the sustainable transition of our society.
Faced with this paradigm shift, academic research plays an important role. At HEC Liège, the School of Management of the University of Liège, a study in the field of finance aims to inform private and professional investors, as well as financial professionals, about the problems of sustainable financing.
What are ESG ratings?
ESG ratings are scores given to companies to measure their environmental (E), social (S) nature or the quality of their governance (G). There are different models. Some follow a quantitative approach and aggregate a set of sub-indicators determined from baseline data (eg greenhouse gas emissions from companies); others add a level of analysis and interpretation. Some ESG valuation models gather information through surveys or discussions with companies; others do so solely on the basis of publicly available documents and information. The object of analysis may also differ: risks and / or opportunities for the development of the company, the impact on stakeholders, as well as analysis that combines these views.
There is also the question of the existence of non-financial sub-indicators on which the ratings are based. There are serious barriers to obtaining information, as very few companies actually report all this information. Rating agencies make assumptions and extrapolate data (usually) based on industry practice. Due to these methodological differences, as well as the lack of access to the same sources of information, agencies provide different ratings.
Impact of information uncertainty
A legitimate question arises as to whether this uncertainty in non-financial information creates confusion among investors when estimating the value of financial assets. A previous study conducted by HEC Liège shows that this uncertainty does complicate the company’s assessment of investors. In addition, there is significant friction between supply and demand in the allocation of capital for sustainable investment: investors demonstrate a limited understanding of ESG in their capital allocation process. The results of a study conducted by HEC Liège even show that investors rely on the name of investment products to make their choice much more than the ESG estimate.
How will the Covid crisis affect investor preferences and awareness? On their investment behavior?
The pandemic has increased investors’ attention to environmental and social issues, as evidenced by increased investment flows in funds with higher ESG ratings. Academic research shows that investors’ concerns about climate change are putting pressure on the cost of financing “green” companies and that the investor is demanding a return bonus.
ESG rating compared to financial indicators
Many studies focus on the predictive nature of ESG’s economic performance. For example, there is scientific evidence that employee welfare is a source of productivity, that environmental risk affects a company’s profitability. The question is whether these ESG estimates are able to cover these elements. A study by HEC Liège shows that these ratings are influenced by characteristics external to sustainability, such as the size of the company or the company’s ability to communicate information. Given these external elements, our results show that the putative link is struggling to survive.