The ESG (environmental, social and governance) ratings industry is a growing market as more investors seek to manage the rising risks posed by non-financial issues.
However, this year, we have seen lively debate about the value and limitations of ESG ratings. What has prompted this anti-ESG movement and what should we make of it?
The challenge of disparate ratings
The main trigger for the ESG rating pushback is the discrepancy between rating providers.
For example, Tesla was removed from the S&P 500 ESG index over concerns about working conditions and automated driver safety, while MSCI ESG gave the company an average rating of A in 2022, highlighting it as a “laggard” in Product Safety & Quality, but a “leader” in Corporate Behaviour.
This is just one of many examples where different ratings tell different stories about the same company.
"The lack of consistency between ratings is significant, with the correlation between major ESG ratings being on average 0.61. This makes them difficult to compare."
Olga Chomereau Lamotte, Investment Consultant, UBP
Since fixed income credit ratings are almost perfectly correlated, it seems obvious to ask why ESG ratings are not.
In the White Paper “How to use ESG ratings smartly”, we therefore explore the reasons behind this variability and provide suggestions on how to use ESG ratings in their current, imperfect state.
Understanding the discrepancy of ESG ratings
The heterogeneity of ESG ratings can be explained by a number of factors, best described by looking at them from three angles.
1. The What
In the absence of a single, established definition of “ESG”, providers are not necessarily measuring the same thing.
A regular criticism in this context is that some companies in inherently “bad” sectors (such as oil) can get high ESG ratings, while others in “good” sectors (such as renewables) can have poor ESG scores.
This is hard to wrap one’s head around. But it helps to remember what ESG ratings are – and what they are not, as highlighted by Meggin Thwing Eastman, ESG Research Director, EMEA at MSCI, in a webinar hosted by UBP in early December.
"ESG ratings tell you how well a company is managing the ESG issues that might have financial relevance for it. They are not a measurement of whether a company is an inherently good or bad actor in the world."
Many ESG rating providers follow a relative approach, comparing companies’ business practices to those of their peers within the same sector, which explains why an oil company can get a high score. But some providers follow an absolute approach, hence giving a lower rating to companies with intrinsically bad business models.
The data is also a challenge since non-financial reporting is not mandatory for corporates (yet), meaning data is scarce, and neither standardised nor audited.
2. The Who
ESG data providers are proliferating. There are more than 140 providers, each different in size, coverage and geography. As no single agency covers all needs, users often have to resort to combining several.
3. The How
Methodologies differ considerably across providers. Measurement (meaning the protocol, standard or scale used) and scope (what is measured) account for most of the variability.
The road ahead
While these factors may explain the discrepancies, two important questions remain. First, what should be done to bring some order into the ESG rating chaos? And what can investors do in the meantime?
Regarding question one, Eleanor Taylor Jolidon, Co-head of Swiss & Global Equities, emphasises the need for harmonisation.
"We need much more coherence in the approach to ratings. There should be rules that all rating agencies follow."
Indeed, regulators are pressing ahead to bring more standardisation into the industry with both EU and UK securities market regulators having released statements on the need for introducing regulatory safeguards for ESG ratings.
In parallel, the EU is increasing requirements for non-financial reporting by corporates via the Corporate Sustainability Reporting Directive (CSRD) from 2024, which will improve data availability.
Turning to question two: until there is greater convergence, the following factors can help investors to use ESG ratings more effectively: first, greater transparency on what is measured and why would allow investors to choose ratings based on their needs; second, comparability would enable investors to compare different methodologies; finally, identifying their most material issues would help investors select providers that best fit their needs.
Therefore, the divergence should not lead us to dismiss the value-added of ESG ratings which already give a significant amount of information and raise the importance of the topic for investors.
Olga Chomereau Lamotte
Investment Consultant
View her Linkedin profile
