25 July 2019
As ESG ratings become embedded in mainstream investment decision making, they are attracting criticism. Is it justified, asks Peter Cripps.
Environmental Finance last year revealed that mining firm Barrick Gold wrote a letter to its shareholders and other stakeholders criticising its environmental, social and governance (ESG) rating from MSCI.
The letter slammed the rating report as distorted and misleading, adding that it "continues to be based on superficial research; inconsistent analysis based on a methodology that is not transparent; and a largely retrospective and controversy-based view of ESG performance".
The spat between the two companies highlights that ESG ratings are becoming increasingly important for companies and their investors.
As ESG ratings are more widely used by investors, they attract increasing levels of scrutiny – and criticism. For example, asset manager Schroders recently described ESG ratings as being "not far from random".
So, what are the strengths and weaknesses of the ESG rating providers, and what do their ratings actually tell investors?
ESG rating companies are not only gatherers of the reported and non-reported data discussed in the previous two articles, but are also a key source of proprietary data, via their surveys and research. As well as providing overall scores or ratings for companies based on their own analysis, they also typically allow access to the data that underlies them. This can be both quantitative and qualitative.
"You can view us as a data provider or a rating provider," explains Bob Mann, president and chief operating officer at Sustainalytics, explaining the company's dual role.
For many investors, ESG rating agencies are the key intermediary between them and the companies in which they invest. Their data – and their ratings – are crucial for ESG-focussed investors.
The field of rating agencies is becoming more sophisticated, as they have access to swelling volumes of data, and as the boom in the demand for their services allows them to scale up their workforce. There has also been consolidation in the market, which has allowed some concentration of resources, coverage and expertise.
One of the key strengths of ESG rating agencies is that they provide independent judgments paid for by investors, rather than companies, says Andreas Hoepner, a professor of operational risk, banking and finance at University College Dublin. This helps eliminate the conflicts of interest that can arise when rating agencies are paid by the companies they rate, as is the case with credit rating agencies.
As demonstrated by the example of Barrick and MSCI, this can lead to controversy. But it at least shows that their views are independent.
"My first question is: 'Who pays for the data?' If the data is independently provided, it's much better," Hoepner argues. "It's necessary that the data is paid for by the buy-side. I think, compared with some financial data, good ESG ratings have less conflict of interest and often more people working on them."
He believes that ESG data is among the most important financial data, behind trading data, for investors, and it is already arguably "more important than credit ratings".
A lack of correlation
Despite their growing popularity, ESG ratings face a catalogue of criticism. For example, renowned UK investor Terry Smith opened fire on the methodology of leading ESG data firm Sustainalytics when launching his Fundsmith Sustainable Equity Fund, in November 2017.
The fund's marketing brochure pointed out that Sustainalytics gave oil and gas company Repsol an overall ESG rating of 88/100 whereas Novo Nordisk, the global leader in medication for diabetes – the world's largest and most rapidly growing medical condition – was given a rating of 85/100. Similarly, mining giant Anglo American was assigned a score of 76/100 whereas Becton Dickinson, a medical technology company, was given 65/100.
"Whilst these scores may accurately reflect ESG performance relative to their sectors, the idea that medical equipment companies can have worse ESG scores than oil & gas and mining companies simply flies in the face of common sense," Smith said.
A more recent critique came from UK-based investment management firm Schroders. Andrew Howard, head of sustainability research at the $537 billion firm, said "it doesn't matter which research or rating firm you look at – there is no consistency in what defines good or bad."
"You're not that far away from it being pure luck, in terms of whether you're going to be well-rated by more than one ESG provider," Howard continued. (See graphic from Schroders.)
Schroders' own assessment framework, called Context, is formed of questions that its investment analysts answer using data they collect on 10,000 companies. It also uses data provided by MSCI and Thomson Reuters.
This lack of consistency in ESG ratings from different ESG rating providers was also explored in a highly critical July 2018 report by right-wing think tank the American Council for Capital Formation (ACCF), called Ratings that don't rate: the subjective world of ESG rating agencies.
It pointed to research from ratings provider CSR Hub that compared MSCI and Sustainalytics ratings for constituents of the S&P Global 1200 index. There was only a weak correlation, of 0.32, between the two firms' ratings, it said. On this scale, a score of 1 would represent complete correlation and minus 1 would represent complete negative correlation.
ACCF said rating agencies in other capital markets are much more closely aligned. It pointed to separate research that showed a strong correlation of 0.9 between the credit ratings of Moody's and S&P. This, it argued, was because the credit rating agencies base their assessments on standardised financial disclosures, whereas this is not the case for ESG data, as discussed in previous articles in this series.
However, University College Dublin's Hoepner argues that this lack of consistency is not necessarily a problem, as long as the methodologies of ESG rating agencies are transparent. He argues that it is acceptable for different methodologies to produce different results, as they may focus on different issues.
"It's only problematic if they say they are reporting the same thing but end up with different numbers," he says.
Matt Moscardi, head of financial sector research at MSCI, agrees: "Discrepancies [between the ratings] are natural because we are using different methodologies.
"I don't think they will ever be the same, although they may get more correlated. But I can't imagine a scenario in which all the ratings converge."
Moscardi says MSCI is becoming more sophisticated in the sectors to which it assigns companies, which can have a significant bearing on its ratings. "We don't compare Facebook and Twitter any more," he explains.
The ACCF report and separate research by Schroders find evidence that ESG ratings have inherent biases, particularly towards large-cap companies.
The ACCF report says an example of large-cap bias is Bristol-Myers Squibb, which enjoyed a higher Sustainalytics rating (73) than its smaller cap fellow healthcare sector bedfellow Phibro Animal Health (46).
The report questioned this judgment, saying that although Bristol-Myers sets ESG targets and reports in line with the Global Reporting Initiative, "the company has been tied to recent high-profile controversies including questionable experimental testing methods and Foreign Corrupt Practices Act violations".
On the other hand, Phibro says it "has a responsibility to deliver safe, effective, sustainable products and to provide expert guidance about their use." In addition, the company runs the educational website animalantibiotics.org to engage stakeholders about animal health issues, including responsible antibiotic use and resistance, the report says.
And the ACCF report says companies from some regions, especially Europe, tend to have higher ESG ratings. It says this may be a result of non-financial reporting requirements in Europe.
For example, it says that BMW has a better ESG rating than Tesla, which it argues cannot be justified seeing as BMW has been embroiled in scandals, and Tesla manufactures electric vehicles, which have a key role to play in the transition to a low-carbon economy.
"In general, ESG rating systems reward companies with more disclosures. It is possible for companies with historically weak ESG practices, but robust disclosure, to score in line with or above peers despite having more overall ESG risk," argues the ACCF report.
However, Moscardi denies that MSCI favours companies that report more. He says that non-reported data, such as information taken from online, is used to help fill the holes in company reporting.
However, he concedes that some regions are more difficult than others to assess, with state-owned companies in Asia "where there's no real disclosure" among the most challenging.
The ACCF report goes on to say there is a lag period, with the scores failing to be adjusted quickly enough following a controversy. An example of this was Volkswagen, whose ESG rating from Sustainalytics did not fall adequately following the emissions test cheating scandal of 2015, the report argues.
"Even after it was discovered that Volkswagen committed one of the most serious clean air violations, it continued to enjoy an ESG rating higher than its peer average," says the report. "The ratings dropped from well above average at 77 to still six points above average at 66 following the scandal becoming public. Even in first quarter 2018, its ESG ratings place the company on par with the rest of the industry."
The ACCF report says ESG ratings are therefore not a good reflection of ESG risks.
"In short, the practice of increased disclosure is given more value by the rating agencies than the underlying risks those disclosures address. Allowing ESG rating agencies to run unchecked in determining significant investment direction is irresponsible and negligent to managers' fiduciary duty," concludes the ACCF report.
To back up its assertions, it quoted a 2016 report by BlackRock, which said: "It is widely believed that ESG investing reduces regulatory and reputational risks. In a large global panel, we find that business ethics controversies and regulatory issues are more likely for firms that disclose a richer set of ESG-friendly policies ... Like most observers, we expected that an ESG-friendly profile would be associated with better social performance. We were wrong."
Hermes Investment Management agrees that ESG ratings, taken on their own, do not adequately reflect risk. Hamish Galpin, lead manager of its Hermes SDG Engagement Equity Fund, says engaging with companies on ESG issues is a better strategy than using "partially informed" ESG ratings. This is particularly true for small and mid-cap companies, where disclosure is often weak.
He cites the example of US marine engine and boat manufacturer Brunswick Corporation, which he considers a "high quality company" that would "likely be less favoured if we relied solely on ESG scores from third-party research houses".
Brunswick, he argues, has improved its corporate governance, its manufacturing facilities have good environmental sustainability credentials, and it has very low employee turnover as well as a high proportion of female employees.
"As disclosures improve, we expect the ESG rating of Brunswick to rise, although it will inherently continue to lag the reality on the ground," he adds. "This case demonstrates the need for credible and meaningful ESG analysis and investors that are committed to this, cannot and should not, depend on ESG ratings.
"ESG ratings can certainly raise red flags about major issues within companies, but in aggregate, the scores have some clear shortcomings."
It seems that these criticisms are resonating with the industry.
Sustainalytics last September changed its methodology from providing ESG scores to ESG risk ratings.
The risk ratings are designed to offer investors a distinct risk signal into why certain ESG issues are considered material for a company and how well a company is managing those risks.
Interestingly, these risk ratings are not sector-specific, which will help negate some of the criticisms mentioned earlier.
Another criticism of ESG ratings is that they don't take into adequate consideration a company's impact on the UN Sustainable Development Goals. (This will be discussed in a forthcoming article on impact reporting, as part of this series of features.)
The second instalment of this feature on ESG ratings providers can be read here. It will explore the benefits of ESG ratings, and will compare and contrast how three different ESG ratings providers assess the same three companies.
This article is part of a series of features exploring ESG data.
- To read 'The ESG data files – introduction, click here
- To read 'The ESG data files – part one: reported data', click here
- To read 'The ESG data files – part two: non-reported data', click here
- To read 'The ESG data files – part three: ESG rating agencies', click here
- To read 'The ESG data files – part four: fixed income data’, click here
- To read 'The ESG data files – part five: the impact of the EU’s taxonomy’, please click here
- To read 'The ESG data files – part six: TCFD and the challenge of looking forward’, click here