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ESG ratings are only an auxiliary tool, says Berenberg

Bias to large and mega-caps, as small firms flag lack of resources as prime obstacle to disclosing data


Elena Johansson

Portfolio managers cannot only rely on environmental, social and governance (ESG) ratings when assessing smaller companies, as they are not adequately evaluated, a study has shown.

Rupini Deepa Rajagopalan, head of ESG office at Berenberg, says that case studies have shown that “smaller companies are often far ahead of the curve and integrate ESG very well, many times without this being recognised and appreciated by rating agencies”.

“Understanding the complexity of a company demands expert knowledge, time and resources.

“We have therefore come to the conclusion that ESG analysis must be done internally and by portfolio managers who make the final investment decisions, and that ratings can only be one auxiliary tool among numerous,” she argued.

In order to evaluate to what extent ESG ratings can account for real world businesses, German asset manager Berenberg compared the coverage of the three biggest ESG rating agencies to examine data gaps and conducted a survey, as well as assessed case studies.

It named them Providers A, B and C.

Coverage skewed towards large-cap universe

While the coverage of mega and large-cap companies is generally good, the firm observed a “steep drop” when it analysed the coverage of lower market caps.

As representative indices for equity universes, it selected the MSCI World, MSCI Europe Micro Cap, MSCI Europe Small Cap and Stoxx 600.

Figure 1 and figure 2 below illustrate the market cap of a number of representative indices and the coverage relative to the absolute number of index participants, respectively.



Bias towards big companies

Another major finding is that ESG ratings are inherently skewed towards large and more mature companies, while small and rapidly growing companies on average have lower ESG ratings.

“Smaller, faster growing companies, which incidentally are the ones we are often most interested in, on average score less well or are not rated at all,” the authors of the study said.

Figure 3 shows the average ratings of the different providers by market cap bucket, evidencing that a better rating is more likely the larger a company is.

In figures 5 to 7, Berenberg analysed the ratings for potential biases towards certain financial characteristics.

It found that, for all three providers, well rated companies (defined as scoring in the top quartile of the overall universe) on average grow sales, EPS and capex slower than those companies that fall into the bottom quartile.

Using the MSCI Acwi as a basis, it also found limitations in the geographic coverage, which is highest in Europe and North America and rapidly drops off beyond these regions (figure 4).

Why are small and midcaps less well covered?

The study explains that the bias towards larger companies stems from the weaker disclosure of ESG data from smaller and less mature firms.

In its survey, Berenberg found that companies see the process of working with numerous existing ESG rating providers as being time consuming.

While they would be willing to improve their ratings, these companies flagged a lack of resources as the prime obstacle to disclosing more data.

When commenting on the weak correlation of scores between the ESG providers, the authors said that this is indicative of the evolving nature of ESG analysis.

“We are still at the beginning when it comes to quantifying ESG risks. Contrasting opinions remain on how risks are best captured in one overall score.

“There is further progress to be made. However, it is also clear that ESG assessments will always remain subjective,” the authors added.


The study says however that ESG ratings “provide a useful first review”.

But it highlights that given “the endless complexities and nuances involved in an ESG analysis standardised and disclosure-reliant scoring frameworks will always struggle to replace” more in-depth analysis by fund managers and engagement.

Matthias Born, head of investments at Berenberg, commented: “There is no standard in ESG assessment existing and also hardly comparability between ratings. An active fund manager can recognise these information gaps and remove them through detailed analysis. In the case of smaller companies, it is even more important because ESG opportunities are not visible by applying ratings.”