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Two Steps Forward

The secret life of ESG ratings

ESG ratings

GreenBiz Group, via Shutterstock

Part One of a three-part series. Read Part Two here. Part Three here.

The letters E, S and G have become so intertwined with the world of sustainability that the three-letter acronym ESG can mean almost anything and, at times, nothing at all. But when it comes to the ratings of companies’ environmental, social and governance policies and performance, those definitions can determine the fate of trillions of dollars of capital.

So, what exactly are ESG ratings? Who creates them and on what basis? What do they mean? How are they used?

Answering those seemingly simple, foundational questions requires understanding the extraordinarily complex world of ESG ratings, as I’ve tried to do over the past few months. What one finds — what I found — is a practice that seems to be roughly equal parts art and science. And while the purveyors of these ratings uniformly pride themselves on the transparency of their methodologies and overall approaches to rating companies, the ratings are largely misunderstood by many outside the investment world, and even by some inside it.

What exactly are ESG ratings? Who creates them and on what basis? What do they mean? How are they used?

In this three-part series, I’ll share what I learned, including what’s working well and what could work better. I hope to demystify the ratings for non-investor readers and provide some much-needed context about what the ratings themselves are — and aren’t.

The series will be in three parts:

  • Part 1, below, focuses on the overall view of ratings and ratings agencies and some challenges they are facing.
  • Part 2 dives into how ratings are created.
  • Part 3 asks, "Are ESG ratings really necessary?"

The basics

ESG ratings are created by both commercial and nonprofit organizations to assess how corporate commitments, performance, business models and structures align with sustainability goals. They are used, first and foremost, by investment firms to screen or assess companies in their various funds and portfolios. The ratings may also be used by job seekers, customers and others in assessing business relationships and by the rated companies themselves to better understand their strengths, weaknesses, risks and opportunities as they seek to align their business strategy with societal expectations and planetary boundaries.

While there are more than a score of ratings agencies, most companies and investment firms I spoke to work with five of the largest: ISS ESG, a division of Institutional Shareholder Services, a proxy advisory firm; Moody’s, the venerable credit rating company; MSCI, which publishes hundreds of indices for global investment markets; S&P Global, the financial analytics firm best known for its stock indices; and Sustainalytics, a division of Morningstar, which provides an array of investment research services. Others of note include Bloomberg ESG disclosure scores, Fitch Climate Vulnerability Scores, FTSE Russell’s ESG ratings and CDP’s climate, water and forest scores.

Each firm assesses thousands of companies — sometimes 10,000 or more — across a broad range of ESG topics and assigns each a rating — a letter grade similar to those used in credit ratings (AAA, A, BB, CCC, etc.), a grade like those used in schools (A-mius, B, C-plus, etc.) or a numerical score (53 out of a possible 100, for example).

Those ratings can loom large for rated companies, helping determine such things as the cost of capital or whether their stock will be included in any of the hundreds of ESG-themed mutual funds or exchange-traded funds. The ratings show up on hundreds of thousands of Bloomberg terminals and other devices. They may be used by media organizations in compiling lists of "best" or "most sustainable" companies; by watchdog groups to ferret out greenwash; and by job seekers to decide which companies to pursue (or avoid). The ratings firms may also confer special status to highly rated companies. ISS, for example, grants "Prime" status to those that "fulfill ambitious absolute performance requirements."

Among the challenges, and a source of frustration to many sustainability professionals, is the complex ratings ecosystem itself: how ratings are created, the methodologies used to rate companies and how difficult it can be for rated companies to change or amend information that’s outdated, incomplete or just plain wrong.

Growing scrutiny

These and other concerns have garnered regulators’ attention on both sides of the Atlantic. The European Commission is in the midst of a targeted consultation on the ESG ratings market in the European Union. Among the issues, according to one commission official, who asked not to be named: "The lack of transparency around methodologies, around data sources, potential conflicts of interest" — some ratings organizations also provide advisory services to the companies they rate — "and the lack of confidence of investors in the functioning of this market." The European Securities and Markets Authority, known as Esma, in February began an inquiry into how ESG ratings work and has raised concerns about potential conflicts of interest.

Both efforts align with that of IOSCO — the International Organization of Securities Commissions — which in November issued a report detailing some challenges with "the role and influences of ESG ratings and data product providers." A fact-finding exercise found that "there is little clarity and alignment on definitions, including on what ratings or data products intend to measure" and "a lack of transparency about the methodologies underpinning these ratings."

There is little clarity and alignment on definitions, including on what ratings or data products intend to measure.

Meanwhile, in the United States, the Securities and Exchange Commission is scrutinizing U.S. credit rating agencies around how they compile ESG ratings. In January, it issued a report noting that the raters "may not adhere to their methodologies or policies and procedures, consistently apply ESG factors, make adequate disclosure regarding the use of ESG factors applied in rating actions, or maintain effective internal controls involving the use in ratings of ESG-related data from affiliates or unaffiliated third parties." (The SEC did not respond to multiple requests for comment.)

All of these watchdogs seek to level the playing field to ensure that companies are being consistently and accurately rated — "to bring further transparency, clarity and credibility" to ratings, as the EU official put it.

Risk and reward

One significant point of confusion is what the ratings themselves actually mean. Many observers may be surprised to learn that one thing they don’t reflect is whether a company is making a positive impact on today’s pressing social and environmental challenges — or corporate goodness, for lack of a better term.

That’s worth repeating: ESG ratings do not necessarily measure whether a highly rated company is an actual leader in reducing its impacts on people and the planet, or whether it is working to build a more just and sustainable world.

What the ratings do reflect is, in a word: risk. That is, "a company’s exposure to industry-specific material ESG risks and how well a company is managing those risks," as the ratings firm Sustainalytics puts it. That, in turn, can help inform whether a company’s environmental, social and governance policies and practices will likely positively or negatively affect its shareholders, or whether a portfolio of highly rated companies will provide superior returns to investors.

As MSCI explains on its website, "ESG ratings focus on financial risks to a company’s bottom line. That is by design to help institutional investors assess such risks and to deploy capital in ways that maximize investment return over their time horizon."

That fact seems to have eluded many sustainability professionals, and even some investors, who believe that investing in an ESG-themed fund means putting their money to work to solve vexing environmental and social problems. And to some extent, that misconception is understandable. MSCI, for example, the largest purveyor of ESG data, touts "Better investing for a better world" on its ESG investing homepage. That marketing message is burnished by thousands of financial advisers and investment firms, from mom-and-pop financial planners to the brokerage behemoth Vanguard, which explains on its website, "More and more people — millennials and women, in particular — consider social and environmental impact as an important part of their investment decisions."

One can rightly assume that the prime motivation of those millennials and women, among others, is to use their investments to make a positive impact in the world, not merely to minimize the risks associated with those investments.

“I think a lot of people don't get that,” Evan Harvey, global head of sustainability for Nasdaq, told me. “I think lawyers get it. I think if you have a sustainability function that's anchored under the CFO … I think that they definitely understand that. But the sustainability people, the corporate citizenship people, the impact people on some level — I don't know that they have that worldview.”

“ESG has nothing to do with making the world a better place,” explained Aniket Shah, managing director and global head of ESG at Jefferies Group, the investment banking firm. “It's a very tough thing for me to say. This is not why I came into this space myself. What ESG has to do within the capital markets is ensuring that you, as an allocator of capital, understand the risks associated with environmental, social and governance issues from the perspective of how do you make the most amount of money in your investments?”

Pointing a finger

The gaping delta between the “better world” meme and what ESG ratings actually measure was the subject of a landmark Businessweek investigation last year into MSCI. Its reporters analyzed every ESG rating upgrade that MSCI awarded to companies in the S&P 500 from January 2020 through June 2021 — 155 companies in all.

“The most striking feature of the system is how rarely a company’s record on climate change seems to get in the way of its climb up the ESG ladder — or even to factor at all,” they concluded. As an example, it cited McDonald’s Corp. The burger giant’s greenhouse gas emissions rose about 7 percent over four years and “generated more greenhouse gas emissions in 2019 than Portugal or Hungary because of the company’s supply chain.” But MSCI gave McDonald’s a ratings upgrade, citing the company’s environmental practices.

Wrote Businessweek: “MSCI did this after dropping carbon emissions from any consideration in the calculation of McDonald’s rating. Why? Because MSCI determined that climate change neither poses a risk nor offers ‘opportunities’ to the company’s bottom line.” This, about a major buyer of beef and other commodities that impact, and are impacted by, the climate crisis.

In 51 of the upgrades, reported Businessweek, “MSCI highlighted the adoption of policies involving ethics and corporate behavior — which includes bans on things that are already crimes, such as money laundering and bribery. Companies also got upgraded for employment practices such as conducting an annual employee survey that might reduce turnover.”

When I asked Linda-Eling Lee, global head of ESG and climate research at MSCI, about the Businessweek story, she pointed a finger at those who, she claimed, are using the ratings for purposes for which they weren’t intended.

The ratings are created for paying clients who understand what they actually mean, she said. “The fact that these ratings are now being consumed more publicly by people who aren't necessarily using it as intended — I think that there is this challenge of people kind of projecting what they think it is. And I think that the world is looking for a measure of what they consider to be corporate goodness — like a good-guys list or a bad-guys list or something like that. We all know that in the media, people like to create these lists in part because the public likes these kinds of lists.”

It's not just MSCI. Every rating agency has versions of this story — ESG scores that don’t adequately reflect a company’s actual policies and performance. And while it’s easy to tar the entire industry with a single brush, the reality is far more nuanced. ESG ratings, and the agencies that produce them, play a positive role for rated companies, investors and others. Critics (and reporters) may cite issues that seem to undermine these agencies’ credibility. But overall, the ratings are well-regarded, even by some of their critics.

Off the rack

Most large investment firms and money managers don’t rely solely on ESG ratings to assess companies and funds in their and their clients’ portfolios. Rather, they use ratings as mere data points, one of several they may factor into their investment advice and decisions, along with corporate sustainability reports, regulatory filings, media reports, in-house research and direct engagement with the companies. ESG ratings inform, rather than drive, most investment decisions.

"I know a lot of institutional investors, they do their own analysis," explained Nasdaq’s Harvey. "They're going to do their own rankings and ratings, but the rating itself that you get from one of the established houses, it does get you entry into the basket. So, you're not even in consideration if you don't pass a certain barrier from those sort of off-the-rack ratings."

Simply because the ratings assess risk doesn’t mean that they aren’t also a proxy for companies making a positive impact.

The ratings also are a handy way to roll up a lot of complex data into a single measure, including weighing seemingly conflicting attributes, explained Richard Mattison, president of S&P Global Sustainable1, the firm’s ESG division. "As we transition to a more sustainable future, we believe that you need to consider a number of different elements in that transition," he told me. "And that's why you look at ESG. You can't just look at one topic in isolation of something else. You'd be investing in companies with poor governance, potentially, but who have a good climate strategy. You’re going to have to balance these things together. It's like anything in the investment world: a balanced approach to assessing risk, a balanced approach to assessing opportunity — that’s what's required."

And simply because the ratings assess risk doesn’t mean that they aren’t also a proxy for companies making a positive impact, said MSCI’s Lee.

When you look at the data, she said, "Companies that actually manage their financially relevant risks, they are more efficient, they tend to be better at managing their workforce in such a way that they want to stay, you actually have more diverse leadership — all those kinds of things that companies are doing that actually improve their business for their shareholders are the sorts of things that I think do have positive externalities that are measurable. It's not a theory."

Beyond grumbling

ESG ratings don’t just benefit investors. Companies, too, for all their grumbling about the travails of working with ratings agencies, have a lot to gain.

I asked Emilio Tenuta, senior vice president and chief sustainability officer at Ecolab, about the benefits to his company from working with ratings agencies. Getting a good rating, he said, "builds our brand and recognizes us as a leader in ESG being core to everything we do."

He continued: "The ratings help us standardize the way we look at ESG metrics. ESG investors like to see there's a recurring thread that Ecolab is at the top of these lists." He noted that a good score also can attract talent. "Human capital management is a big deal for us. Half of our associates are in the field working alongside our customers."

Suzanne Fallender, vice president, global ESG at Prologis, agrees. A good rating "helps in talking to employees, it helps in talking to executives. When we are rated by outside groups that say, ‘You are strong across all these different ESG topics,’ it gives that validation that we're on the right track. It helps to have those discussions of where we want to continue to evolve or continue to invest in ESG integration across the business."

But Ecolab’s Tenuta also expressed frustrations. One is that the ESG raters place Ecolab in the same sectoral box as Dow, BASF and other large chemical companies, despite that "we have a very different business strategy." As a result, Ecolab gets assessed and rated on the same factors as Big Chemical. "That becomes challenging because we're evaluated against those criteria, which doesn't necessarily align with what we do."

Still, Tenuta had mostly good things to say about the ratings firms important to Ecolab. "They enhance our ability to engage as a convener. Our company wants to be recognized as a thought leader in water." The ratings, he said, "go a long way to recognize that leadership."

Next: How ESG ratings are built

Thanks for reading. You can find past articles here. Also, I invite you to follow me on Twitter and LinkedIn, subscribe to my Monday morning newsletter, GreenBuzz, from which this was reprinted, and listen to GreenBiz 350, my weekly podcast, co-hosted with Heather Clancy.

 

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