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ESG Ratings: Four Myths And A Truth

Published: July 13, 2016

BannerRecent criticisms of ESG ratings reflect an outdated and inaccurate notion of the ingredients and value of an ESG rating.

Demand for environmental, social, and governance (ESG) analysis has accelerated significantly over the past decade. Such information used to be consumed almost entirely by specialized teams of sustainability experts in investment houses. Increasingly, it is being accessed by a much wider range of professionals across investment teams, risk management, and product development, all with different processes and objectives, and varying levels of ESG knowledge.

Supply of ESG analysis has also changed. What once passed for ESG analysis was composed of little more than a simple aggregation of company disclosures in sustainability reports or from surveys. Today, applying analytical tools and modeling techniques to wider datasets beyond corporate disclosure has significantly improved the rigour, consistency, and relevance of ESG information to the investment process. The result is that suppliers of ESG research have been able to make a clearer distinction between providing a vast library of ESG data points that are designed to be mixed and matched by institutional investors with increasingly varied uses for ESG information; and providing ESG ratings. In fact, ESG ratings aim to serve one specific use case: providing a measure of ESG-related risks and opportunities that might be overlooked by conventional financial analysis.

The rapid change in the landscape for ESG analysis can be confusing. Recent critiques of ESG ratings in particular reflect an outdated and inaccurate notion of what goes into an ESG rating. I address four popular myths about ESG ratings — and acknowledge that there is truth to one widespread belief about ESG fund ratings.

Myth #1: ESG ratings capture a wide range of issues, most of which are not investment relevant…

Only a handful of ESG issues are material to a company. This is fairly intuitive and supported by recent studies, such as the Harvard Business School and Calvert Investments ‘Focus on Materiality’ research, and a number of ESG research methodologies today take this into account. MSCI ESG Ratings, provided by MSCI ESG Research, for example, are highly industry specific. We developed a unique model variant for each of the 150+ Global Industry Classification Standards (GICS) sub-industries composed of the four to eight key ESG issues we have identified as material to the industry. For example, the ratings for Banks, Energy Equipment & Services and Automobiles share only one common ESG issue in their models: corporate governance, which we determined is significant to all three industries (and the only issue that we consider for all companies). The selection and weighting of ESG issues for each industry are highly systematized and regularly reviewed, starting with a quantitatively-driven selection method and ending with incorporating institutional investor client feedback during an annual comment period.

A key difference between historical ‘rating’ methodology and ESG Ratings today that employ a wider set of data to pinpoint relevant issues is really a matter of ingredients. Historically, ESG ratings might have taken an ‘everything-but-the-kitchen-sink’ approach – i.e., throwing in as many ESG data points as possible. Today, the rigorously industry-driven approach is widely accepted among institutional investors undertaking ESG integration, as it is designed to produce a measure highly concentrated on only the ESG issues relevant to that industry.

Myth #2: …which is why ESG ratings often miss big events.
With its 150+ pages of corporate sustainability reporting, Volkswagen topped the charts of some sustainability rankings last year. Hence ESG sceptics gleefully pointed this out as a big miss by sustainability analysts the world over. More than anything, the alleged miss may have been a case of investors not fully understanding the differences in ESG Rating approaches.

The truth is that MSCI ESG Research emphasized VW’s corporate governance issues in its ESG rating, reflecting an approach that considers peers, context, and material risk management. Deterioration in VW’s corporate governance scoring led to its removal from the MSCI ESG Indexes three months before the scandal – and the company was rated second from bottom among European automakers, only slightly outscoring Porsche Automobile Holding SE, its owner. VW was never included in the MSCI SRI Indexes.

That’s not to suggest that we called this or any other scandal. The point of ESG ratings is not to detect fraud or predict future events. But we see increasing evidence that ESG ratings, done right, can help flag outliers that are more vulnerable to incidents of ethics breaches, accidents, litigation and more. It is a tool for gauging important but intangible qualities of operational integrity and risk oversight, which are hard to discern across a large, diversified portfolio.

Myth #3: ESG ratings are biased toward companies with large CSR departments.
Some companies spend more time than others to present their sustainability credentials in the best light. Often sustainability reports include information on philanthropic and charitable activities that are not material to the core business model. That’s why a robust ESG ratings model does not rely solely on corporate disclosure. Approximately half of the MSCI ESG Ratings methodology is driven by business segment information that we have mapped to over 50+ data sources, such as water basins data from the World Resource Institute, biodiversity data from The Nature Conservancy and World Wildlife Federation, toxic waste data from the Toxics Release Inventory, safety and labour statistics from the International Labour Organization, and health statistics from the World Health Organization. This type of analysis allows us to get a more objective view of a company’s exposure to ESG-related risks that are not tied to a company’s ability to promote its sustainability credentials.

It also allows us to calibrate for a company’s size. While larger companies tend to have more resources for ESG reporting, they often also face higher exposure to ESG-related risks due to complexity of their operations and global footprint. By offsetting disclosure against the level of risk exposure in the model, we have been able to better address this size bias. In fact, research by MSCIESG Research and others has corroborated the notable dissipation of a size bias over time. (2)

Myth #4: ESG ratings differ so much between different ratings agencies because they are totally subjective.

Arguably, myths one through three boil down to one simple thing: different research firms produce different ESG ratings. This is not primarily because ESG is inherently subjective and value judgments differ between analysts.

There are systematic reasons behind why one methodological approach produces certain ratings versus another. Just as we can attribute financial performance to different risk and return drivers, we can break down the components that account for a certain ESG rating.

Let’s return to VW’s ESG rating as an example. We ran two scenarios (for more detail watch ‘Up in Smoke: Lessons Learned from the Volkswagen Scandal’ – time stamp 43:13) using data for the company’s 2015 ESG rating. In scenario one, we ran the model ‘as if’ all ESG issues in the database should be relevant and should be equal weighted. Under this outdated ‘kitchen sink’ ESG scenario, the company’s rating in the three years prior to the scandal would have been boosted by one to two full notches compared to the actual rating. In the actual rating, only five ESG issues carried varying weights in the model for the automobile industry. In May of 2015, for example, instead of its actual rating of BBB rating on a scale between AAA (best) to CCC (worst), VW would have been rated a AA had all ESG issues been considered in its ESG rating.

In scenario two, we ran the model ‘as if’ we only have corporate disclosed ESG information as data inputs. Under this ‘disclosure only’ scenario, the company’s rating would also be boosted by one full notch, compared to the actual rating at the time of scandal, which illustrates the effect that assessing ESG risk exposure calculated from additional data sources can have on an ESG signal. Over a four-year period (2012-15), the actual ESG ratings for VW were consistently lower compared to both scenarios.

The point is: methodology matters. There are systematic and transparent reasons for why ESG ratings differ from one another, and anyone using ESG ratings can and should know what drives those differences.

Grain Of Truth

And now for the grain of truth: A fund manager’s ESG strategy cannot be captured by a fund rating.

ESG ratings and data have long been used by institutional investors to evaluate the ESG characteristics of their portfolios. This capability has recently been formalized into ESG ratings and metrics for mutual funds and ETFs. It is a hallmark of our times that we seek to condense information into a simple ranking or rating, even if we know that the #4 lodging on TripAdvisor, a charming bed and breakfast, is qualitatively different from the #3 lodging, a chain hotel with excellent Wi-Fi.

MSCI ESG Fund Quality Scores are not designed to convey the quality of a fund manager’s ESG strategy, capabilities, or intentions. We are very explicit about that. The fund scores are based solely on the underlying holdings and their management of medium- to long-term ESG risks and opportunities. They are useful as a quick snapshot summary of the holdings.

They cannot tell you whether a manager has a specific ESG strategy or thematic approach, or whether they engage with poor performing companies. We leave that to the manager to decide whether and how they want to disclose that information, and to the investor to understand and conduct due diligence on the managers’ approaches.

While a fund’s ESG Quality Score by itself speaks only to the quality of the holdings in aggregate, additional data transparency is available to provide a glimpse into unintentional or intentional exposures an investor in the fund might capture. For instance, – how much of Fund A’s holdings generate revenues from clean technology or what is Fund B’s carbon footprint are questions investors can start to answer by picking and choosing between a wide range of 100+ metrics through which to analyze and compare funds.

Understanding The Signal

Though there remains much hand-wringing over that ONE fund score, the agitation may be misplaced. The real problem is using ‘the score’ without understanding the signal. The truth is that no one measure at the fund level can capture the rich and varied dimensions of ESG characteristics that different investors might care about.

What our ESG Quality Score and the ESG Fund Metrics data do provide is a new conversation for investors, with new investor segments gaining access to the ESG characteristics of what they own. Their questions about what the data suggests (and what it doesn’t) will shape improved versions to come. For the present, managers and investors alike will confront a different perspective on what they hold and why they hold it, spurring innovative new approaches to understanding and managing ESG risks and opportunities.

 

(1) Chava, S. 2011. Environmental Externalities and Cost of Capital Lansilahti, 2012; Credit Suisse; Deutsche Bank; MSCI ESG Research, et al. Huang, 2010; Bhagat and Bolton, 2008; Cremers et al., 2005; Deutsche Bank, 2012 et al.
(2) Nagy, Kassam and Lee, 2015 Can ESG Add Alpha?MSCI ESG Research Jussa, J et al, 2013 The Socially Responsible Quant, Deutsche Bank

 

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