ESG ratings still play an important part in investors’ due diligence processes, but they are no longer among the leading sources of information guiding their decisions, a recent survey has concluded.
Increased scrutiny of ratings agencies by regulators and government bodies, as well as improved means of gathering ESG data, mainly through the use of artificial intelligence, have eroded the usefulness of the metrics supplied by companies including S&P Global, MSCI and FTSE4Good.
Nevertheless, more than half of respondents engage with ratings products more than once a week, and with more sustainable finance regulation expected to be enacted, investment professionals anticipate increasing their use of ratings in the near future.
“After a period of rapid product growth, the market is now being shaped by greater scrutiny of sustainability claims, new disclosure requirements, more sustainable finance regulation and increased direct regulation of ESG ratings providers,” the report concluded. “The shift to a broad integration of ESG criteria does not necessarily translate into a reduced interest in ESG ratings or data and could very well increase it.”From One to Six
The survey of 53 investment professionals conducted on behalf of the ERM Sustainability Institute found that ESG ratings and scores had fallen to sixth place in the list of most important sources of information on the sustainability performance of investment instruments. In 2023, when the survey was first conducted, they were the most important source.
“The findings reveal how much more investors have come to value in-house research and direct company engagement over ESG ratings scores,” the report of the survey stated. “Investors appear to place greater weight on sources that allow for more context, control, and proprietary analysis.”
“Since 2023, the use of media sources, public disclosures, and regulatory databases has increased considerably. This may reflect growing investor use of Al-enabled search, news aggregation, and controversy monitoring tools to gather and interpret public information at greater scale.”
Movement Backlash
The survey findings were published shortly before the UK’s Financial Conduct Authority (FCA) this week announced its final draft of requirements it expects of providers to improve transparency, governance and conflicts of interest.
Scrutiny of ESG ratings has been building for many years and pre-dates a backlash against the sustainability movement that has gained ground in the past five years. Even when ratings were widely used, they were criticised for lacking transparency into their methodologies, with critics often deriding them as “black boxes”. The fact that there was little consistency in the ratings of different agencies also attracted scepticism.The FCA said its new rules are aimed at making ESG ratings more transparent, reliable and comparable; supporting better decision-making and greater confidence in the market; and are meant to be proportionate and support growth in sustainable finance.
Opinion has been mixed on how well ratings reflect actual ESG performance of rated companies and how they can improve investment returns. Research by index provider Scientific Beta concluded that integrating ESG metrics into portfolio calculations had limited benefits for investors. Bloomberg, meanwhile, said there are high correlations between its ESG scores and strong portfolio returns.
Data, Not Scores
The ERM Sustainability Institute survey also found a number of other trends within the ESG ratings space.
- Investors increasingly value the data underlying ESG scores, even though the use of both has declined. The data – including sub-scores and company-level information – is more frequently used and fed into proprietary models.
- While market participants consider ratings as credible and high-quality sources of information – and still use more than one provider – their engagements with them have become more limited. They are also trending towards smaller agencies.
- Investors are more critical of ESG ratings than the agencies’ corporate customers, reflecting their utilisation of the data for more critical operational use cases.
- Investors are increasingly looking at the quality of underlying data and rating methodologies when choosing a ratings and score provider.
Optimistic View
The findings were not all gloomy for agencies, especially the larger ratings providers such as MSCI, which was ranked highest among investors for perceived quality and usefulness. CDP, EcoVadis, S&P Global ESG and RepRisk rounded out the top five.
As well, implementation of ESG regulations, especially in the European Union, is likely to stimulate more use of ratings, with the larger providers set to benefit most, the report stated. As their use of the data and products increases, a large majority of investors expect to apply AI to enhance data quality and validation.
Experts have urged caution on the findings of the survey. Daniel Cash, a ratings researcher at Aston University in the UK and a Senior Fellow at United Nations University Centre for Policy Research, said few solid conclusions on changes in preferences should be taken from the relatively small number of professionals questioned.
“There is evidence that investors value external ESG information but increasingly want to undertake their own analysis, determine which considerations matter and reach their own judgements,” Dr Cash told Data Management Insight. “That does not mean they are becoming independent of rating providers. In some cases, quite the opposite.”
Cash also questions some of the survey’s assumptions, noting there is little agreement between investors on what constitutes ESG performance, and adds that it is difficult for them to “expect consistent ratings when the underlying evaluative objectives can legitimately differ”.
“I would distinguish between investors who have the resources to construct proprietary assessments and those who do not,” he added. “For sophisticated institutions, the underlying information, coverage and integration with internal systems may be particularly valuable.
“For others, the finished rating remains an important analytical resource. External ratings also acquire particular significance when incorporated into benchmarks, investment mandates and financial products.”
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