What’s wrong with ESG ratings?

According to Jay Clayton, chairman of the US Securities and Exchange Commission, they are “over-inclusive and imprecise.” Researchers at MIT Sloan characterized their effect as “aggregate confusion.” And on a recent Euromoney podcast, Peter Bakker of the World Business Council for Sustainable Development described them as “a bit of a zoo”.

These days, it can seem as though no one has a good word to say for environmental, social and governance (ESG) ratings. Are they really so unfit for purpose? And if so, why are investors still using them?

One of the main criticisms levelled at the industry is the wide divergence of ratings on offer from different providers. The MIT Sloan study, published last year, found that the average correlation between ESG ratings from six leading providers was 0.61. The researchers contrasted this with the 0.92 correlation between credit ratings provided by Moody’s and Standard & Poor’s.

This has been widely cited as evidence that ESG ratings are unfit for purpose – but such criticism misses the point in several respects.

Criticisms

For one thing, there is the question of whether it makes any sense to invite comparisons between credit ratings and their ESG counterparts. All credit ratings, irrespective of provider, attempt to provide an answer to one simple question – what is the probability of default on a given debt instrument?

With ESG ratings, there is no consensus even on what questions should be asked – but that is hardly the fault of the ratings providers. Politicians, regulators and investors across the globe are still struggling to agree on a definition of sustainability, let alone set standards for the industry. Why should rating agencies be any different?

Many investors, indeed, say they value the diversity of ESG ratings, in so far as they reflect the methodologies of providers with different backgrounds and specialisms – provided, of course, that these are fully disclosed.

In the past, that was not always the case, but over the past two years, transparency has become the new industry watchword. There are still some mutterings from investors about black boxes, but most agree that the depth and breadth of information available has improved considerably.

Politicians, regulators and investors across the globe are still struggling to agree on a definition of sustainability, let alone set standards for the industry. Why should rating agencies be any different? 

A more cogent criticism of ESG ratings – and the one made by Clayton – concerns the value, and indeed propriety, of aggregating data on topics as diverse as human rights and waste management into a single score.

This would indeed be hard to justify were it not for the fact that, even today, it is what many investors want.

One ratings industry insider cynically suggests that this is so that they have someone to blame in the case of any ESG shortcomings in their portfolio. Others see it as indicative of a lack of genuine commitment to sustainability. Buying ESG ratings, they say, allows investors to pay lip service to the concept.

Yet if the demand is there, it is hard to blame the rating agencies for meeting it – particularly when most are happy to provide much greater levels of granularity for those who want it.

Indeed, the fact that market leader MSCI made its headline ESG ratings free to access in November may suggest that the value of such overall scores is decreasing as investors delve deeper into sustainability topics and demand more nuanced data.

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Failures

Most recently, ESG rating providers have come under fire for failing to spot governance and social failures, respectively, at Wirecard and Boohoo.

With Wirecard, the criticisms are perhaps less justified. Fraud is always difficult to spot and the payments provider had the full weight of the German establishment behind it. What is more, many rating providers did flag allegations of wrongdoing in their real-time “controversy assessments”.

Boohoo is a tougher one. Concerns about labour violations in the company’s UK supply chain were raised by a local non-governmental organization as early as 2017. More to the point, it is hard to see how a firm in an industry as inherently unsustainable as fast fashion could score highly on ESG; yet Boohoo had stellar ratings from some of the leading providers.

What the sceptics have usually failed to offer, however, is a viable alternative 

These incidents have clearly highlighted issues with ESG ratings that need to be addressed – as many in the industry are happy to acknowledge. At the same time, the reaction to them has at times seemed disproportionate.

Boohoo and Wirecard have been used as another stick with which to belabour ESG ratings by the still large cohort of market participants who remain suspicious of the industry and, indeed, the whole concept of sustainable investment.

What the sceptics have usually failed to offer, however, is a viable alternative – or, indeed, recognition of the challenges involved in providing metrics that will allow investors to compare the ESG performance of thousands of companies in a world with few disclosure requirements and no standardization of data.

Clearly, ESG ratings are imperfect, but providers are well aware of that. They are also unanimous in their desire for better disclosure and more standardization of data. In the meantime, they are providing a service that investors are urgently demanding with the tools currently at their disposal.

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