Keeping score: The truth about ESG ratings

As sustainable investing grows in popularity, how can we distinguish truly sustainable companies and funds from greenwashing? To help investors with this question, a growing number of companies offer ratings which rank stocks or funds based on a variety of ESG metrics. However, these ratings can sometimes be more of a hindrance than a help.

Lack of consistency

One of the main issues is that as of today there are no specific regulatory requirement for ESG data, research and ratings providers to be transparent and consistent. However, as sustainable investing becomes more popular, the growing need for reliable data has led to a proliferation of companies offering ESG ratings at a stock, fund and asset manager level. In total, Research Affiliates identifies some 70 different firms that provide some sort of ESG rating data today.

ESG ratings at a stock (company) level are particularly important for passive sustainable funds, which often rely on ratings data specialist rating providers to construct the portfolio. According to a report by the Sustainability Institute, the key providers of these stock ratings are MSCI, Thomson Reuters, Sustainalytics, S&P Global, Bloomberg, CDP, ISS, RobecoSAM and Vigeo Eiris. Many of these firms and others, including Morningstar, FE fundinfo and Square Mile Research, also offer ESG ratings on funds. These aim to help both retail and professional investors avoid greenwashing and gain better insight into sustainable investment strategies – but again, they lack consistency and they can be very subjective. To complicate matters further, many asset managers, especially the larger ones, have their own in-house ESG teams which conduct proprietary research on the stocks they invest in.

The main problem is that each rating firm or asset manager have their own methodology, which means that the same stock can have a high ESG rating according to one provider, but not another. For example, some rating providers score Facebook in the top decile of the investment universe, while others rate it below average, depending on what ESG factors they take into account. Many give Facebook a low score on governance (the G in ESG), citing concerns over its privacy practices, as well as hate speech and misinformation on the platform. However, the company tends to score highly on environmental issues (the E in ESG) for its pioneering commitment to green data centres. Since different rating providers give different weightings to E, S and G issues, the overall ESG score for Facebook can vary wildly. So, what does that mean for a sustainability focused fund? Do they include or exclude Facebook? Well, that depends on the (fairly arbitrary) choice of ESG rating provider they have decided to follow.

The problem is exacerbated by the lack of standardised reporting on ESG issues and limited availability of ESG data. It is particularly problematic when it comes to the small-cap space, where there is less rigorous reporting than the large-cap space. As a result, it is even more difficult to provide accurate ratings on small-cap stocks.

You can see how all of these issues lead to inconsistent, subjective ratings that lack transparency, which can be a real hindrance for fund managers and the end investor, contrary to the original purpose.

Regulatory change coming

Thankfully, there are some regulatory initiatives on the horizon that will hopefully level the playing field and provide greater transparency. This year will see the new EU Sustainable Finance Disclosure Regulation (SFDR) come into force, with which asset managers across Europe will have to comply. These new disclosures will apply in the EU from 10 March 2021. Under these rules, European asset managers will have to publish policies on their websites outlining how they integrate sustainability risks into their investment processes. They must also be able to explain in a transparent way how their investment decisions could potentially have an adverse impact on sustainability factors.

SFDR is not expected to be a regulatory requirement in the UK, but large asset management firms will be expected to start reporting in line with the Task Force on Climate-related Financial Disclosures (TCFD) from 2022 (at the moment this reporting is voluntary). Companies will have to report on how their governance and strategy are affected by climate-related risks and opportunities, how they conduct risk analysis on climate issues and what metrics and targets they use to do so.

The EU will also see the introduction of a new Taxonomy Regulation, which will introduce labelling for financial products to make it easier for investors to compare ESG investments like for like – and to avoid greenwashing. There are also additional proposals for further specific regulation of ESG data which would focus more closely on data and ratings providers.

As is the case with many things in life, ESG rating providers have good intentions. The problem is that because of the lack of transparency and consistency they often leave their audience more confused than reassured. As a result, ESG ratings should not only be taken with a pinch of salt, but you should also look beyond the rating. When it comes to funds, finding out the philosophy and process is usually a good start to understand how important (and integrated) ESG issues really are. And when it comes to individual stocks, there is a ton of research you can do to find out which environmental, social and governance issues the company really cares about (or has prioritised) and then make up your own mind on which issues matter more. The Facebooks of this world will always be one person’s villain and another one’s hero

But there is light at the end of the maze. With new regulation on the horizon driving consistency and increased transparency, it hopefully won’t be long before ESG ratings will do what they always intended to do – separate the truly sustainable stocks and funds from the imposters.

Date of publication: 20th January 2021