Breakdancing has been approved as a sport for the Paris 2024 Olympic Games. Unfortunately, events scored subjectively lack the quantifiable certainty of “faster, higher, stronger.” Efforts to add judging rigour to figure skating, gymnastics and other unquestionably athletic activities still leave them open to controversy. Environmental, social and governance (ESG) measurements face a similar challenge.
Interest in ESG investing has exploded in recent years, fuelled mainly by environmental concerns. With Wall Street’s endorsement, ESG and thematic investing have given new life to active managers, who have seen US$1.7 trillion in U.S. domestic equity fund assets flow to low-cost passive products between 2010 and 2019.
But the lack of uniformity in ESG measurement poses problems. Fixed income ratings from Moody’s and Standard & Poor’s have a 99% correlation, according to Princeton University economist Burton Malkiel. The correlation between ESG rating agencies including MSCI, Sustainalytics, Moody’s, S&P Global/RobecoSAM and FTSE Russell/Refinitiv is between 38% and 71%, as stated by a 2019 study from researchers at the Massachusetts Institute of Technology.
Absent standards, consensus and uniform terminology, rating criteria is strongly influenced by those doing the rating. How can investors navigate the evolving ESG space and get what they want from the mountain of data points, which are often categorized in different ways?
Understanding ESG ratings
Many ESG services rank all companies within an industry. Some oil producers, for example, will score better than others. Companies with diverse businesses will overlap and ESG raters can overemphasize industry issues, obscuring company-specific risks. Is buying the top-rated company in every industry what your client wants?
Large companies tend to score higher as they have more resources dedicated to ESG reporting. Raters rely on self-reporting, so scores may skew toward report volume rather than ESG excellence (see Chart 1).
Regulation also matters, as companies in regions with higher reporting requirements score better. Europe takes ESG seriously. Not only are reporting requirements stiffer than in North America, but European fund managers have tended to place more emphasis on ESG investing. The volume and quality of reporting — rather than ESG practices — could account for the higher ratings by geographic area (see Chart 2).
Rating companies also use different scoring methods. While MSCI grades companies on a scale from AAA to CCC, similar to what bond rating agencies use, other firms — including Sustainalytics —score companies from 0 to 100.
MSCI works with BlackRock and iShares, giving it an advantage in the ETF and retail space. The firm’s institutional following includes Allianz, BMO Asset Management, Manulife Investment Management, Mercer Investments, Morgan Stanley, Northern Trust Asset Management and PIMCO.
Sustainalytics, acquired by Morningstar last year, has relationships with BNY Mellon, City of London Investment Management and the Norwegian Government Pension Fund, and offers online access to company ratings for free.
ESG ratings are inconsistent across rating companies, but the most influential rating firms will capture the most attention regardless of the quality of their scoring. You need to know their strengths and weaknesses so you can explain their processes to clients when recommending investment products. Access to ratings is also essential.
During the Cold War, figure skating adjudication hinged on the votes of Eastern Bloc judges using politicized standards. We can hope that breakdancing won’t be as polarized — and that transparency in ESG scoring will continue to improve. To pick the winners in the meantime, watch the Russian judge.