ESG credit ratings and scores for companies and financial products have come under sharp focus in the past year as the profile of sustainable finance has risen.
They form core components of many financial institutions’ asset discovery and risk-mitigation strategies, offering easily digestible assessments of sustainability risks. They also underpin a multitude of indexes that the more than 700 ESG-linked funds rely on as benchmarks. With an estimated US$35 trillion set to have been invested in sustainable assets by the end of the decade, ratings and their compilers are shouldering a lot of expectations.
But these measures are not without controversy. Myriad rating and scoring methodologies based on a variety of often porous data sets have resulted in many entities receiving widely different ratings from separate assessors. That’s raised questions about the reliability of the gauges and is making comparisons across assets difficult, leading to concern that the ratings could be missing important details. The OECD went as far as to ask whether ESG ratings were fit for purpose.
Even as regulators in Europe and the US mull bringing ESG assessors under their scrutiny amid worries that investors could be misled, the ratings universe grows ever bigger. Only this week, French credit ratings agency and ESG data provider Qivalio, bought Spain’s Axesor Rating.Qivalio said it will forge what it says will be the first European rating firm to focus on ‘double materiality’ – basing its calculations on the European Union’s assessment that the impacts a company’s activities have on the environment and society are material to the risks it faces. Other methodologies look at the risks environment and society place on enterprises.
Qivalio’s sales pitch underlines a key reason why ratings companies have such contradictory scores: they are working to different briefs.
“When you look at the major credit raters, there’s probably an 80% to 90% overlap in terms of how they score companies, whereas within the ESG world, the methodology to get from underlying data to reading or score can vary from company to company significantly,” Eli Reisman, Director of Product Development at FactSet tells ESG Insight. “They will take the data set and layer analysis on top of that, and that analysis usually comes in the form of a proprietary materiality framework – they essentially have a weighting of what’s important for each company.”
The rationale for that is understandable. ESG is a much broader topic than straightforward credit ratings, which rely on easily obtained company-reported data. Reporting companies have grown accustomed to the practice over the 100-odd years that ratings have been offered.
By comparison ESG reporting, which is still in its infancy, is scrappy; companies often don’t know what they should disclose and reporting standards are yet to be harmonised in the way they are for credit ratings. As well as that, the topic is much broader – companies are expected to provide data on their environmental, social and governance performance and risks.
All major credit rating agencies offer ESG ratings. S&P Global, Fitch, Scope and Moody’s Investors Service jostle for impact investors’ business with data providers and indexing firms like Refinitiv, Sustainalytics and MSCI.
Many other companies, including Bloomberg and RepRisk, score firms on their disclosure records, measures that are often used by ratings firms to assess the same companies.Lukas Brochard, Global Associate Director at ESG data and ratings provider CDP, says the breadth of content that must be covered by an ESG rating is important to consider. Asset managers may find ratings that are weighted towards risks associated with greenhouse gas emissions less relevant if they are investing in low-carbon industries.
The lens that’s applied will influence what data is sought and how it’s used, giving a score that will be different from that of other assessors.
“It’s not just about the financial flows that a corporation or individuals are facing, it is also a lot of other material or issues that need to be considered within a larger context,” he tells ESG Insight. “And it is not easy to know which one of these issues is going to be topical and which ones aren’t going to be topical for risk assessment opportunities and ultimately for measuring the impact on value.”
Nevertheless, differences in ratings that are based on apparently similar data sets are causing handwringing among investors and regulators. Red flags have been raised regularly over companies being given healthy ratings despite links to fossil fuels. The ratings of Wells Fargo, Citigroup and Morgan Stanley were upgraded this month despite having combined investments in polluting companies, Bloomberg News reported this month.
Earlier this week, UK-based think tank International Regulatory Strategy Group (IRSG) called on overseers to turn their gaze to ratings, arguing that they lack transparency and put investors at risk of greenwashing. Leaving them unregulated will undermine green finance markets, the organisation wrote.
“Increased efforts are required to improve the quality, consistency, and availability of the underlying data to ensure market confidence in ESG products,” the group states in a publication produced with Accenture.
The IRSG’s calls on the Financial Conduct Agency to act follows the regulator’s own announcement late last year that it was considering bringing ESG ratings under its purview. The European Union’s European Securities and Markets Authority (ESMA) this month launched its own investigation into whether it should take similar actions.
And in the US, the Securities and Exchange Commission said it had identified potential conflicts of interest in ratings firms offering ESG scores with their credit rankings.
How effective regulation will be is up for debate. Some, like EDM Council’s Global Head of Industry Engagement and Senior Advisor for ESG Eric Bigelsen, are concerned the market won’t be sufficiently consulted.
“The challenge is, do they just put out regulation and say ‘comply with it’,” Bigelsen says. “If you look at what happened with MiFID as an example, they came up with a construct, put it in the marketplace and the marketplace had to figure out how to comply. Not the easiest thing to do and maybe not the best approach to take.”
The usefulness of an ESG rating, however accurate and detailed the data may be, is also being questioned.
A single aggregated score can never accurately reflect the complexity of every company’s sustainability record, CDP’s Brochard says. His organisation provides ratings based on its own sourced data. An oil company can still get a good rating if it actively discloses great governance performance data but holds back on its drilling activities.
Brochard argues, however, that ratings should be seen only as proxies, indicators of other broader considerations.
What’s likely in future, he and Reisman argue, is that ratings companies will increasingly differentiate according to the various aspects of ESG, and asset managers will make their decisions based on a range of specialised ratings providers.
“I’m not sure that ESG will go the way of credit ratings where there’s two major providers, and that’s it,” said Reisman. “I think you have a lot of different players out there, all of whom are sort of providing a different perspective.”
Others aren’t so sure.
Regulators are keen to ensure easy access to all ESG data through better disclosure and standards setters are showing signs of forming a consensus on what should be reported. When that time comes ratings won’t matter, argues Joseph Vicari, Managing Director at Broadridge, which produces a rating-of-ratings for companies.
“I personally think that ratings may begin to fade at some point, and that it’s really the underlying data that everybody will want,” Vocari says.
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