The secret life of ESG ratings

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

The letters E, S and G have turn into so intertwined with the world of sustainability that the three-letter acronym ESG can mean almost anything and, at times, nothing in any respect. But in the case of the rankings of corporations’ environmental, social and governance policies and performance, those definitions can determine the fate of trillions of dollars of capital.

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

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

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

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

The series shall be in three parts:

  • Part 1, below, focuses on the general view of rankings and rankings agencies and a few challenges they’re facing.
  • Part 2 dives into how rankings are created.
  • Part 3 asks, “Are ESG rankings really obligatory?”

The fundamentals

ESG rankings are created by each business and nonprofit organizations to evaluate how corporate commitments, performance, business models and structures align with sustainability goals. They’re used, initially, by investment firms to screen or assess corporations of their various funds and portfolios. The rankings might also be utilized by job seekers, customers and others in assessing business relationships and by the rated corporations themselves to raised understand their strengths, weaknesses, risks and opportunities as they seek to align their business strategy with societal expectations and planetary boundaries.

While there are greater than a rating of rankings agencies, most corporations and investment firms I spoke to work with five of the biggest: ISS ESG, a division of Institutional Shareholder Services, a proxy advisory firm; Moody’s, the venerable credit standing company; MSCI, which publishes a whole lot 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 rankings and CDP’s climate, water and forest scores.

Each firm assesses 1000’s of corporations — sometimes 10,000 or more — across a broad range of ESG topics and assigns each a rating — a letter grade much like those utilized in credit rankings (AAA, A, BB, CCC, etc.), a grade like those utilized in schools (A-minus, B, C-plus, etc.) or a numerical rating (53 out of a possible 100, for instance).

Those rankings can loom large for rated corporations, helping determine things like the fee of capital or whether their stock shall be included in any of the a whole lot of ESG-themed mutual funds or exchange-traded funds. The rankings show up on a whole lot of 1000’s of Bloomberg terminals and other devices. They might be utilized by media organizations in compiling lists of “best” or “most sustainable” corporations; by watchdog groups to ferret out greenwash; and by job seekers to make a decision which corporations to pursue (or avoid). The rankings firms might also confer special status to highly rated corporations. ISS, for instance, grants “Prime” status to people who “fulfill ambitious absolute performance requirements.”

Among the many challenges, and a source of frustration to many sustainability professionals, is the complex rankings ecosystem itself: how rankings are created, the methodologies used to rate corporations and the way difficult it might be for rated corporations to alter or amend information that’s outdated, incomplete or simply plain improper.

Growing scrutiny

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

Each 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 rankings and data product providers.” A fact-finding exercise found that “there’s little clarity and alignment on definitions, including on what rankings or data products intend to measure” and “an absence of transparency in regards to the methodologies underpinning these rankings.”

There may be little clarity and alignment on definitions, including on what rankings or data products intend to measure.

Meanwhile, in america, the Securities and Exchange Commission is scrutinizing U.S. credit standing agencies around how they compile ESG rankings. In January, it issued a report noting that the raters “may not adhere to their methodologies or policies and procedures, consistently apply ESG aspects, make adequate disclosure regarding the usage of ESG aspects applied in rating actions, or maintain effective internal controls involving the use in rankings of ESG-related data from affiliates or unaffiliated third parties.” (The SEC didn’t reply to multiple requests for comment.)

All of those watchdogs seek to level the playing field to make sure that corporations are being consistently and accurately rated — “to bring further transparency, clarity and credibility” to rankings, because the EU official put it.

Risk and reward

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

That’s value repeating: ESG rankings don’t necessarily measure whether a highly rated company is an actual leader in reducing its impacts on people and the planet, or whether it’s working to construct a more just and sustainable world.

What the rankings do reflect is, in a word: risk. That’s, “an organization’s exposure to industry-specific material ESG risks and the way well an organization is managing those risks,” because the rankings firm Sustainalytics puts it. That, in turn, can assist inform whether an organization’s environmental, social and governance policies and practices will likely positively or negatively affect its shareholders, or whether a portfolio of highly rated corporations will provide superior returns to investors.

As MSCI explains on its website, “ESG rankings concentrate on financial risks to an organization’s bottom line. That’s by design to assist institutional investors assess such risks and to deploy capital in ways in which maximize investment return over their time horizon.”

That fact seems to have eluded many sustainability professionals, and even some investors, who imagine that investing in an ESG-themed fund means putting their money to work to resolve vexing environmental and social problems. And to some extent, that misconception is comprehensible. MSCI, for instance, the biggest purveyor of ESG data, touts “Higher investing for a greater world” on its ESG investing homepage. That marketing message is burnished by 1000’s of monetary advisers and investment firms, from mom-and-pop financial planners to the brokerage behemoth Vanguard, which explains on its website, “Increasingly more people — millennials and ladies, specifically — consider social and environmental impact as a crucial a part of their investment decisions.”

One can rightly assume that the prime motivation of those millennials and ladies, amongst others, is to make use of their investments to make a positive impact on the earth, not merely to attenuate the risks related to those investments.

“I feel a number of people do not get that,” Evan Harvey, global head of sustainability for Nasdaq, told me. “I feel lawyers get it. I feel if you’ve gotten a sustainability function that is anchored under the CFO … I feel that they definitely understand that. However the sustainability people, the company citizenship people, the impact people on some level — I do not know that they’ve that worldview.”

“ESG has nothing to do with making the world a greater place,” explained Aniket Shah, managing director and global head of ESG at Jefferies Group, the investment banking firm. “It’s a really tough thing for me to say. This is just not why I got here into this space myself. What ESG has to do throughout the capital markets is ensuring that you simply, as an allocator of capital, understand the risks related to environmental, social and governance issues from the angle of how do you make essentially the most amount of cash in your investments?”

Pointing a finger

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

“Probably the most striking feature of the system is how rarely an organization’s record on climate change seems to get in the best way of its climb up the ESG ladder — and even to factor in any respect,” they concluded. For instance, it cited McDonald’s Corp. The burger giant’s greenhouse gas emissions rose about 7 percent over 4 years and “generated more greenhouse gas emissions in 2019 than Portugal or Hungary due to the company’s supply chain.” But MSCI gave McDonald’s a rankings upgrade, citing the corporate’s environmental practices.

Wrote Businessweek: “MSCI did this after dropping carbon emissions from any consideration within the calculation of McDonald’s rating. Why? Because MSCI determined that climate change neither poses a risk nor offers ‘opportunities’ to the corporate’s bottom line.” This, about a serious 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 company behavior — which incorporates bans on things which are already crimes, similar to money laundering and bribery. Corporations also got upgraded for employment practices similar to conducting an annual worker survey that may reduce turnover.”

Once I asked Linda-Eling Lee, global head of ESG and climate research at MSCI, in regards to the Businessweek story, she pointed a finger at those that, she claimed, are using the rankings for purposes for which they weren’t intended.

The rankings are created for paying clients who understand what they really mean, she said. “The undeniable fact that these rankings are actually being consumed more publicly by individuals who aren’t necessarily using it as intended — I feel that there’s this challenge of individuals type of projecting what they think it’s. And I feel that the world is in search of a measure of what they consider to be corporate goodness — like a good-guys list or a bad-guys list or something like that. Everyone knows that within the media, people prefer to create these lists partly because the general public likes these sorts of lists.”

It isn’t just MSCI. Every rating agency has versions of this story — ESG scores that don’t adequately reflect an organization’s actual policies and performance. And while it’s easy to tar all the industry with a single brush, the fact is way more nuanced. ESG rankings, and the agencies that produce them, play a positive role for rated corporations, investors and others. Critics (and reporters) may cite issues that appear to undermine these agencies’ credibility. But overall, the rankings are well-regarded, even by a few of their critics.

Off the rack

Most large investment firms and money managers don’t rely solely on ESG rankings to evaluate corporations and funds of their and their clients’ portfolios. Moderately, they use rankings as mere data points, considered one of several they could factor into their investment advice and decisions, together with corporate sustainability reports, regulatory filings, media reports, in-house research and direct engagement with the businesses. ESG rankings inform, somewhat than drive, most investment decisions.

“I do know a number of institutional investors, they do their very own evaluation,” explained Nasdaq’s Harvey. “They will do their very own rankings and rankings, however the rating itself that you simply get from considered one of the established houses, it does get you entry into the basket. So, you are not even in consideration should you don’t pass a certain barrier from those kind of off-the-rack rankings.”

Just because the rankings assess risk doesn’t mean that they aren’t also a proxy for corporations making a positive impact.

The rankings are also a handy approach to roll up a number of complex data right 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 imagine that it’s essential consider quite a lot of different elements in that transition,” he told me. “And that is why you have a look at ESG. You may’t just have a look at one topic in isolation of something else. You would be investing in corporations with poor governance, potentially, but who’ve climate strategy. You’re going to should balance this stuff together. It’s like anything within the investment world: a balanced approach to assessing risk, a balanced approach to assessing opportunity — that’s what’s required.”

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

Whenever you have a look at the info, she said, “Corporations that truly manage their financially relevant risks, they’re more efficient, they have an inclination to be higher at managing their workforce in such a way that they need to stay, you really have more diverse leadership — all those sorts of things that corporations are doing that truly improve their business for his or her shareholders are the styles of things that I feel do have positive externalities which are measurable. It isn’t a theory.”

Beyond grumbling

ESG rankings don’t just profit investors. Corporations, too, for all their grumbling in regards to the travails of working with rankings agencies, have lots to realize.

I asked Emilio Tenuta, senior vp and chief sustainability officer at Ecolab, in regards to the advantages to his company from working with rankings agencies. Getting rating, he said, “builds our brand and recognizes us as a pacesetter in ESG being core to every thing we do.”

He continued: “The rankings help us standardize the best way we have a look at ESG metrics. ESG investors prefer to see there is a recurring thread that Ecolab is at the highest of those lists.” He noted that rating can also attract talent. “Human capital management is a giant deal for us. Half of our associates are in the sector working alongside our customers.”

Suzanne Fallender, vp, global ESG at Prologis, agrees. An excellent rating “helps in talking to employees, it helps in talking to executives. After we are rated by outside groups that say, ‘You might be strong across all these different ESG topics,’ it gives that validation that we’re on the precise track. It helps to have those discussions of where we wish to proceed to evolve or proceed to take a position in ESG integration across the business.”

But Ecolab’s Tenuta also expressed frustrations. One is that the ESG raters place Ecolab in the identical sectoral box as Dow, BASF and other large chemical corporations, despite that “we now have a really different business strategy.” Consequently, Ecolab gets assessed and rated on the identical aspects as Big Chemical. “That becomes difficult because we’re evaluated against those criteria, which does not necessarily align with what we do.”

Still, Tenuta had mostly good things to say in regards to the rankings firms necessary to Ecolab. “They enhance our ability to have interaction as a convener. Our company desires to be recognized as a thought leader in water.” The rankings, he said, “go a protracted approach to recognize that leadership.”

Next: How ESG rankings are built

Thanks for reading. You’ll 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 hearken to GreenBiz 350, my weekly podcast, co-hosted with Heather Clancy.



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