“ESG ratings vary … depending on the provider chosen, which can occur for a number of reasons, such as having different frameworks, measures, key indicators and metrics, data use, qualitative judgement and weighting of sub-categories”. This quote from the Organization for Economic Co-operation and Development (OECD), 2020 ‘ESG Investing: Practices, Progress and Challenges’. ESG Investing: Practices, Progress and Challenges (oecd.org) nicely summarizes the current challenges with ESG ratings.
Environmental, Social and Governance (ESG) factors are being used increasingly by the investor and finance communities to assess the sustainability and risk profile of companies.
ESG considerations can have a range of impacts on an organization’s financial performance and underlying shareholder value with multiple bodies of research pointing to a positive correlation between financial performance and strong corporate ESG policies and practices.
An ESG rating is one of the tools used in assessing the sustainability and risk profile of a company and is intended to measure a company’s resilience to longer-term, material, environmental, social and governance (ESG) risks. They can also be used to assess a company’s ESG performance and exposure to ESG risks and how well the company manages those risks, relative to their peers.
Given the appropriate and intensifying focus on ESG and on climate risk in particular, along with a surge of ESG-related finance products and the consequential heightened regulatory scrutiny, we have seen significant growth in the number and type of ESG ratings, and rating providers.
This rapid growth in an industry that has been without regulatory oversight has introduced a number of challenges:
- Unlike credit ratings, ESG ratings from different providers are not tightly correlated, making comparability more difficult.
- Lack of standardization across metrics and differing definitions across providers results in confusion and disparate measures.
- It is often cited that third-party vendors don’t always provide the appropriate level of transparency around methodologies.
- End users need to understand key differences between rating providers when comparing ratings from different sources.
Who are the ratings providers?
ESG ratings providers are firms that research and evaluate sustainability policies of public traded companies. Research conducted in 2019 identified that there were more than 650 providers worldwide, used by two thirds of investment managers and they range from single issue Non-Government Organizations to comprehensive for-profit global businesses such as Bloomberg, Fitch, S&P and MSCI. Unlike the credit rating agency model, the ESG rating providers typically operate a user-pays model.
Witnessing the significant growth and focus on ESG, several ratings providers have recently responded with new and exciting product offerings, most of them in their own right being very powerful additions to the toolkit. The challenge is, given the historical lack of regulatory oversight and the consequential lack of standardization, comparability across these providers is often very difficult.
What is the impact?
A lack of standardization drives additional complexity which typically drives cost, and often drives increased risk. It can also make data consolidation and summarization more difficult, error prone and time-consuming and sometimes impossible.
Consider the typical investment manager or an LP in the private equity space, tasked with assessing the underlying ESG risk in an investment portfolio and faced with numerous submissions from multiple providers covering a multitude of variables that do not always share a common definition. As discussed in more detail in my recent article in ESG Today, they are often short on expertise and short on time and resources. What helps and what hinders is very clear in this ecosphere.
Needing to analyze and interpret numerous ESG rating submissions and having to understand key ESG definitional differences between providers and the further implications thereof doesn’t quite reconcile with ‘Standardization, simplicity and transparency’, or ‘Focus on material issues’.
And focusing on what matters does matter
For PE firms, focusing on materiality in the context of ESG can be very meaningful. Research has shown that PE firms who focus on material ESG factors can benefit significantly. A 10-year back-test on public equities identified that ‘while going long on superior ESG performers generates excess performance of about 1 percent a year, going long on superior ESG performers only in those areas of materiality extends the excess return to 4 percent a year.’ Conversely, shorting poor performers in material areas of ESG generates an additional 4 percent of alpha per year.
(Source: Financial Times April 6, 2020. Minor, Argos Global Advisors, Letter: Perhaps the new alpha mantra should be ESG materiality | Financial Times (ft.com)).
What is being done to address the ESG ratings situation?
Given that climate change is the most significant challenge of our time, setting common global standards is a necessary first step to promote a base level understanding.
Hope is on the horizon. Just last year, some of the major standard setters came together, recognizing the need for common standards and definitions and efforts are now underway to do just that and to have it ready for COP26 in Glasgow later this year.
Regulators have also recognized the need for action. In Europe, the European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, has written to the European Commission (EC) in January 2021, recommending amongst other things that; “there should be a common definition of ESG ratings that covers the broad spectrum of possible ESG assessments currently on offer. You can read more here … ESMA calls for legislative action on ESG ratings and assessment tools (europa.eu)
In the USA, calls for standardization have been getting louder, supported by a recent statement from the SEC where they referred to “the potential development of a single set of global standards applicable to companies around the world”.
Let’s hope standard-setters develop the most prudent, common-sense and understandable standards that can then be adapted, adopted and implemented as expeditiously as practicable.