Bias in ‘opaque’ ESG rating methodologies could lead to underperformance
ESG ratings are “subjectively assessed and opaque” and need to be overhauled to focus on strategic and behavioural change rather than commitments and disclosure, according to research from Imperial College London.
The business school analysed 1,300,000 corporate initiatives since the mid-1990s covering 18,000 companies across all sectors and headquartered in 86 countries. It looked at initiatives around the UN’s Sustainable Development Goals (SDGs), behavioural content and stakeholder beneficiaries.
It found a problem lies in the measurement carried out by ESG ratings, which have a “bias towards disclosure and compliance rather than concrete action” and reward what is easy to audit, such as a group’s commitments and targets, rather than progress. They also neglect what matters most, the school said, which is strategic and behavioural change.
The report A Behavioural Revolution: Sustainability Actions that Create Alpha, said: “For more than four decades, one question has dominated research, policy, and practice: does sustainability pay? The results have been contradictory. Some studies claim positive correlations between corporate sustainability and financial returns, others report neutral or negative effects. This ambiguity has frustrated investors, regulators, and business leaders alike.
“The root of the problem lies in measurement. [ESG] ratings reward preparation, not transformation and investors relying on them risk underperformance.”
It added that ESG ratings are “missing the mark” and highlighted that focusing on disclosure and commitments has little or no impact on profitability and stock returns.
“The result: ESG-driven portfolios systematically misallocate capital, overweighting procedural compliance and risk-management, while underweighting transformative innovation.”
It called on the financial sector to transform ESG ratings by grounding decisions in behavioural indicators rather than static ESG scores so “investors can unlock superior returns while simultaneously closing the SDG financing gap”.
It highlighted the UN estimates that achieving the SDGs require $5trn per year of additional investment and even a 1% reallocation of the $566trn the global financial market holds in assets would be sufficient to close the gap.
In the UK, ESG ratings will become a regulated activity under the Financial Conduct Authority (FCA) from June 2028 if new proposals are approved, with ratings providers required to publish minimum disclosures about methodologies, data sources, conflicts of interest and objectives.