The Bottom Line: Scrutiny of ESG ratings identifies challenges and signals to investors to take an active due diligence role to understand their fund’s strategies.
Sustainable investors should take on a more active due diligence role to understand the sustainable strategies pursued by their funds and ensure continued alignment with their sustainable investment preferences
Financial regulators in the US and overseas along with other stakeholders have more recently been stepping up their attention on environmental, social and governance (ESG) ratings, highlighting the challenges and potential conflicts of interest involved in ESG rating and scoring systems. In recent months, these have included reports and letters issued by the Securities and Exchange Commission Office of Credit Ratings, the European Securities Markets Authority (ESMA) and the UK government. Some of the concerns identified by these and other stakeholders range from the need for definitional requirements, methodological variations and limited transparency involved with ESG ratings, low correlations of ESG ratings across firms, the existence of a positive rating bias toward larger rated entities, and conflict of interest situations. These considerations, some of which merit more attention than others, reflect the complexities associated with the still evolving nature of ESG ratings, their schema and their use. ESG ratings are still ill defined and subjective in nature. The rely on incomplete publicly available historical data for the most part they serve a variety of purposes. Nevertheless, ESG ratings are frequently used by asset management firms to construct sustainable portfolios and carry out their sustainable investing mandates. For sustainable investors allocating funds to active and passively managed mutual funds and ETFs, these challenges signal that they should take on a more active due diligence role to understand the sustainable strategies pursued by their portfolio of funds, their reliance on external ESG data sources to implement their strategies and to ensure continued alignment with their sustainable investment preferences. A three-step process is proposed for current and future sustainable investors in active and passively managed funds that consists of contacting their financial advisor and/or their fund’s investment management company and conducting independent research.
Definitions vary, but ESG ratings attempt to measure and portray the ESG characteristics or profile of various entities
ESG ratings, which are historical in nature, represent environmental, social, and governance ratings or grades that attempt to measure and portray the ESG characteristics, profile, resilience or risk of various entities. These consist of corporations, financial institutions, sovereign and sub-sovereign entities, including municipal governments, securities transactions of various types as well as mutual funds and ETFs. While ESG frameworks and ratings throughout the world may number over 600 according to some estimates¹, including specialized firms that may focus on a singular category such as the environment or governance, the leading ESG rating and scoring firms include MSCI, Sustainalytics, ISS, Refinitiv and Bloomberg. Additional firms have more recently entered the ESG scoring and rating space, differentiated, in part, by their methodologies and data gathering approaches that rely on big data and artificial intelligence.
ESG rating firms employ various data gathering approaches to collect publicly available information, for the most part, supplemented by various statistical techniques for filling in missing data points. On top of that, judgements are involved, terms and definitions are not standardized, their rating and scoring methodologies vary and the meaning of the scores as well as their expressions vary, sometimes resulting in low correlations across ratings offered by offered by different firms. In contrast, credit ratings tend to be highly correlated across credit rating firms. Credit ratings have a commonly accepted definition of creditworthiness which is forward looking, they may have access to non-publicly available financial and strategic information that companies may share with rating analysts and the performance of credit ratings and changes to credit ratings over long periods of time, are tracked and publicly disclosed in the form of rating transition and performance studies. Equivalent metrics on the ESG ratings side are not available and the ability to evaluate their quality is, in turn, limited.
That said, the aggregate scores are widely used, especially in the construction of ESG indices used to structure index funds, even as more recently there is a shift in favor of placing increasing reliance on the underlying data by larger asset management firms, in particular.
¹ Source: The SustainAbility Institute.
Recent regulatory initiatives have been launched in Europe and the U.S.
By way of examples, the European Securities Markets Authority has raised some specific issues regarding ESG ratings, including the lack of a legally binding definition and comparability among providers of ESG ratings or legal requirements to ensure transparency of underlying methodologies of such ratings. In addition, ESMA has highlighted concerns around protection against conflicts of interest that may arise in the business models of these providers. According to ESMA, these result in the risks of capital misallocation, product mis-selling and greenwashing are high while, at present, there are no appropriate legal tools to address these issues. Separately, in a report issued by the UK government in October 2021, it was observed that ESG data providers offer assessments that “may not always be comparable” with “more gaps and assumptions” than ratings in other areas of the market, making them susceptible to greenwashing. The UK is reportedly considering bringing ESG data providers under the regulation of the Financial Conduct Authority (FCA) in a bid to improve transparency and data integrity.
More recently in a report dated January 2022, the Securities and Exchange Commission turned its attention to ESG. A report on Nationally Recognized Statistical Rating Organizations (NRSROs) notes that NRSROs and their affiliates have developed and are offering an increasing number of ESG-related products and services. Development in the area has grown rapidly, and competition has increased among NRSRO and non-NRSRO providers, leading the Staff to identify several areas of potential risk to NRSROs. These include the risks that, in incorporating ESG factors into ratings determinations, NRSROs 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 staff also identified the potential risk for conflicts of interest if an NRSRO offers ratings and non-ratings ESG products and services.
In the light of challenges associated with ESG ratings, investors can pursue a three-step process
In the light of the challenges involving ESG rating and scoring systems and debates that are expected to continue for some time, what if anything should investors who are interested in sustainable investing do at this time?Below are proposed courses of action for investors in actively managed funds as well as index tracking funds. These apply to both existing and new sustainable investors.
Source: Sustainable Research and Analysis LLC
In each case, investors may consult with their financial advisor (if they retain one) to obtain the relevant information. Investors, independent or otherwise, can reach out directly to the investment management company of their fund and they can also conduct their own supplementary research. Index tracking fund investors, in particular, would benefit by consulting their fund’s prospectus (www.sec.gov/edgar/searchedgar/mutualsearch) as well as the tracking index construction methodology document that is generally posted online and can be found via a Google search.
