Managing misconceptions about ESG data
There’s a lot of misunderstanding of what goes into an ESG rating – and how they can be used. MSCI ESG Research’s Nadia Laine sets the record straight
Environmental Finance: MSCI ESG Research provides ESG ratings for more than 13,500 companies. How do you rate a company?
Nadia Laine: Our ESG ratings measure how exposed a company is to material industry risk and assess whether these risks are being adequately managed or mitigated. The overall rating indicates whether a company is a leader or laggard in its industry and is designed to flag outliers that might be more vulnerable to ESG issues.
Our ratings are highly industry specific, with unique model variants for each of the 150-plus GICs sub-industries, with each variant comprised of the four to eight key ESG issues we identify as being most relevant to the industry. We then measure the specific level of risk exposure to these issues at the company level, and review each company’s management systems, targets and any performance indicators to consider how it is managing that risk.
EF: Given the large number of ESG indicators, how do you determine which are the most relevant for a particular company’s financial performance?
NL: The selection and weighting of indicators for each industry are highly systemised, and we review them on an annual basis, starting with a quantitatively driven selection method and ending with a client consultation process, where we seek feedback from investors using our data on any new ESG issues we are proposing to add, and to any changes to weightings.
EF: Large companies are typically more able to collect and report ESG data. How do you avoid bias against smaller firms?
NL: It’s important that a robust ESG ratings model doesn’t rely solely on corporate disclosure. Around half of the average MSCI ESG Rating is built on business segment information, revenues and assets that we’ve mapped to dozens of data sources, such as water data from the World Resources Institute, or biodiversity data from The Nature Conservancy and WWF, safety statistics from the International Labour Organization, etc.
While large companies tend to have more resources for ESG reporting, they also often face high exposure to ESG-related risks due to the complexity of their operations and the size of their footprint. By offsetting disclosure against the level of risk exposure in the model, we’ve been able to address the size-bias challenge.
EF: How do you challenge the assumption by some investors that ESG ratings are ‘backward-looking’ and based on 12- or 18-month-old data?
NL: While any reported data, financial or non-financial, is by definition backward looking, the ESG Ratings model is explicitly designed to be forward looking, as it is designed to identify gaps in a company’s ESG risk management which may lead to vulnerability to future adverse events.
To correct a misconception: many of the datasets underlying the ESG Ratings model are in fact updated dynamically and reflect the latest information. Any data we get from news sources on a significant controversy, for example, or from the latest proxy filings are reflected in updated reports.
EF: Why is there not greater correlation among the ratings produced by different ESG rating providers?
NL: There are systematic reasons why ESG ratings can differ, the most important of which is that different ESG scoring approaches might aim to capture different things. For example, is the ESG rating a measure of the level of disclosure? Or is it designed to identify the level of exposure to ESG risk? Does it incorporate a wide range of ESG indicators, or is it only focused on what is most relevant for each sector? Is it an absolute signal, or is it industry relative? These factors can lead to significant differences in ratings.
EF: What is the relationship between MSCI ESG Ratings and financial performance?
NL: While past performance is not indicative of future results, recent research – published in the Journal of Portfolio Management – examined the ESG ratings of 1,600 stocks over 10 years. It found that companies with high ESG ratings demonstrated lower systematic risk profiles (i.e. lower costs of capital and higher valuations) and lower idiosyncratic risk profiles (higher profitability and lower exposure to tail risk), than companies with low ESG ratings. The study also found companies with the lowest ESG ratings were three times more likely to experience drawdowns over the previous 10 years.
For more information, see www.msci.com/esg-investing
