ESG ratings: Are they useful tools for advisors?

The number of ESG ratings and rankings can create a crowded and confusing picture for investors.

There are more than 40 ESG ratings, 150 rankings and 450 indices, according to the World Business Council for Sustainable Development. But as quality information about funds’ practices becomes more important for advisors, a lack of standardization and transparency means scores can vary depending on which company is providing the rating.

In an analysis for the CFA Institute, Kevin Prall, business valuation technical director at the International Valuation Standards Council, compared ratings from six ESG ratings providers for 400 companies across 24 industries. He found that different ratings methodologies tell vastly different stories about the same companies due to the immaturity of the current ESG ratings environment and transparency issues.

“Every ESG rating provider has a unique methodology. As a result, ratings providers often provide conflicting information about a company's ESG performance,” Prall said in an email to Financial Planning. “Such differences can be small, but often are stark as one provider may rate a certain company as a top performer both in absolute terms and relative to industry peers, while another would rate the same company as below average.”

Comprehensive ESG ratings like MSCI, S&P and Sustainalytics should have a high correlation, Prall wrote. But MSCI’s correlation with both S&P and Sustainalytics is below 50%, he found. The S&P and Sustainalytics correlation is higher at 65% but still not terribly close.

For comparison, Prall also looked at long-term debt ratings for the same firms and sectors. The Standard & Poor’s, Moody’s and Fitch Ratings scores showed correlations between 94% and 96%.

ESG factors have become central tenets for investors and corporations, Prall said, making it a necessity to incorporate ESG considerations into fundamental analyses.

“ESG ratings are a means to assimilate such information, but it's important to understand their limitations as they currently exist,” he said. “Due to the lack of uniformity, it's important to think holistically and recognize that ESG ratings are just one input to consider in a fundamental analysis.”

The S&P and MSCI did not respond to requests for comment.

Visibility into the rating methodology is important in order to compare different ESG ratings, Prall said, because it would allow an analyst to use their judgment to reconcile differences. 

“Currently some ESG ratings agencies provide very good visibility, while others provide very little,” Prall said.

Academics at the MIT Sloan Sustainability Initiative are also researching the measurements and methodologies of ESG rating agencies in their Aggregate Confusion Project to improve the quality of ESG measurement. They found a lack of transparency contributing to a “ESG rating divergence is not merely driven by differences in opinions, but also by disagreements about underlying data,” MIT researchers wrote in a report published in 2019.

MIT Sloan professor Roberto Rigobon said certain measurements, like carbon dioxide emissions, could also be an imperfect way to see if a company’s values align with a client's because of the chain reaction that could occur when a big company purchases clean energy. He said if a tech company moves to a state with clean energy and consumes all of it, leaving the residents with dirty energy, it should not be rated as a good ESG company.

“Just because a company has a good rating does not mean it’s good,” and the opposite could be true as well, Rigobon said in an interview.

In the report, researchers called for greater transparency from companies.

“First, ESG rating agencies should clearly communicate their definition of ESG performance in terms of scope of attributes and aggregation rule,” they wrote. “Greater transparency on methods would allow investors and other stakeholders, such as rated firms, NGOs and academics, to evaluate and cross-check the agencies’ measurements.”

Advisors who are interested in investing in ESG companies can do their own analysis, using a variety of well-established ESG ratings systems like Morningstar, Sustainalytics and MSCI.

Here come the regulators

One solution frequently mentioned in the industry is having the SEC regulate ESG ratings as they do with other forms of financial data. But if the regulator gets involved, a truly independent committee is needed, and not one steeped in politics like the SEC, Rigobon said.

“This is very difficult to measure, so we need something different,” he said.

The SEC warned against investors placing faith in ESG ratings this year, noting that data may be unreliable.

"Some factors are not defined in federal securities laws, may be subjective and may be defined in different ways by different funds or sponsors. There is no SEC ‘rating’ or ‘score’ of E, S and G that can be applied across a broad range of companies, and while many different private ratings based on different ESG factors exist, they often differ significantly from each other,” the regulator wrote in a February investor bulletin. “Third-party scores also may consider or weight ESG criteria differently, meaning that companies can receive widely different scores from different third-party providers."

Whether or not the SEC should be involved in ESG ratings is a topic of debate, but there are parallels with debt ratings, which have specific objectives and regulations from the SEC’s Office of Credit Ratings.

Simon MacMahon, executive vice president of ESG research at Sustainalytics, which was acquired by Morningstar, said he anticipates ESG ratings firms will be regulated “to some degree” in the future.

“It's just important that the regulations are targeted and proportional, with a focus on ensuring high-quality standards and firms’ ratings methodologies are transparent. We believe if the regulators start to require that ESG ratings agencies use one methodology that it would stifle innovation,” he added.

He noted Prall’s analysis did not use his firm’s flagship ESG Risk Rating, introduced in 2018. Sustainalytics developed a new materiality-focused ratings framework to better meet the needs of its institutional clients, which were becoming increasingly sophisticated in their use of ESG information.

MacMahon said many of Sustainalytics’ institutional clients use their data as building blocks to create their own signals and ratings or in conjunction with competitors’ offerings. Not all ratings evaluate the same criteria, he noted, and institutional clients appreciate the diversity of opinion and signals they receive from different agencies. But one of the challenges Sustainalytics faces is the quality and quantity of ESG information available today given corporate disclosure on ESG issues remains largely inconsistent.

“This is a double-edged sword because part of the reason ESG information is inherently valuable is because it is difficult to work with. It's generally been hard to attain,” MacMahon said. “The quality is sometimes not what it needs to be, so it requires a lot of energy and sophistication to collect that information, to normalize it, to quality check it and to put it into consistent frameworks where it actually provides meaningful signals.”

Like all market inefficiencies, this is where money can be made — where the alpha is — if investors know what to look for.

“That creates opportunities for investors, because the information is perhaps a little bit inefficient, it can be valuable,” he said.

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