Market Monitoring - 04/25/2019
ESG Ratings – A look at the ESG ratings landscape
A look at the ESG ratings landscape.
Who rates your company’s Environmental, Social and Governance (ESG) performance?
- The rapid growth of ESG capital and investments has created the need for accurate and reliable ESG data and analysis.
- Several firms have emerged to provide investors with research and ratings on the ESG profile of companies.
- These firms apply a variety of methodologies to attempt to assess risk and establish relative ESG comparisons for investors.
- Despite rigorous and well-intentioned methodologies, there are several criticisms of these ratings.
With nearly a quarter of global assets now managed with consideration of ESG performance, both active and passive investors are adapting their analytical framework in order to better understand each company’s ESG profile. This has led to a surge of ESG rating firms, which have created methodologies in order to help investors rate and compare the ESG performance. As such, companies and IR professionals are looking to better understand how the buy-side is evaluating their ESG profile and the implications for their investor outreach.
In this blog, we’ll look at some of the firms paving the way forward in ESG research and ratings, discuss how they compare with each other and present some early criticisms of ratings providers. We hope to leave you with a better understanding of this rapidly growing investment trend.
Morgan Stanley Capital International (MSCI ESG) is one of the largest providers of ESG research, ratings and indices. With a team of nearly 200 analysts, it rates over 7,000 companies globally with research and rankings used by more than 1,000 institutional investors including 46 of the top 50 worldwide.
Its methodology consists of compiling data from government sources, NGOs, company filings, sustainability reports and media/social media outlets. They then look to identify the most significant ESG risks and opportunities for the company and industry, the timeline of those factors (medium or long term) and how management has navigated them.
Companies are rated on an AAA-CCC scale based on the standards and performance of their industry peers, with AAA being best practices and CCC the worst. To award a grade, MSCI divides the ESG pillars into 10 themes, then 37 different “key issues” (13 Environmental, 15 Social and 9 Governance). It assigns a 0-10 score for each key issue based on exposure and management. Next, it formulates a weighted average score for each key issue, theme and pillar based on each company’s unique core business and industry.
After awarding a score for each of the ESG pillars, MSCI adjusts the score relative to industry peers and assigns the final grade. The grades are fully reviewed on an annual basis, but there is an ongoing evaluation process that monitors news daily and prepares updated reports weekly. Significant news or changes can trigger a full re-evaluation and grade adjustment. Companies can receive a full complimentary report by contacting MSCI at firstname.lastname@example.org.
Whereas MSCI’s ESG ratings focus on both risks and opportunities relative to peers in their analysis, Sustainalytics focuses on how ESG factors contribute to financial risk. The company rates 9,000 companies globally in its coverage universe and just recently revamped its approach to ESG ratings in September 2018. Essentially, it is doing away with ESG ratings based on comparing issuers with industry peers and is now providing each company with an ESG risk rating instead.
Its methodology differs from other rating providers in that it seeks to determine the manageable and unmanageable ESG-related risks of each company. This allows Sustainalytics to evaluate performance based on manageable risk and manageable performance by analyzing company policies and practices. It divides companies into five risk categories: negligible, low, medium, high and severe. By focusing on isolating each issuer’s “manageable risk”, it provides investors with a better side-by-side comparison to analyze ESG risk regardless of the sector or industry.
Sustainalytics’ scoring system ranks companies from 0 to 100, with 100 being the highest risk and 0 being the lowest. The review process is ongoing, ratings can be changed at any time based on current events. A full review occurs annually. Companies are given two weeks to review a draft of the rating and make any comments or suggestions. Any issuer can request its complimentary ESG Risk Rating Report by contacting Eric Fernald, Director of Sustainalytics’ Issuer Relations at email@example.com.
ISS is another ratings provider to consider. ISS combines its long history of proxy advising and governance expertise with newly acquired companies (Ethix SRI Advisors, Climate Neutral Investments, Oekom AG) and strategic partnerships (RepRisk) to add social and environmental factors and provide overall ESG analysis and ratings.
Its ESG ratings are segmented by multiple scores. The ISS Quality Score for governance practices analyzes more than 200 factors divided into four pillars: board structure, compensation, audit risk and shareholder rights. Companies are invited to participate, review and verify information. Scoring is ranked by deciles 1st-10th, with 1st decile being the highest-quality governance practices relative to other companies.
The ISS E&S Disclosure Quality score evaluates 380 environmental and social factors which vary by industry group. Companies are compared to peers in their industry group to establish a decile ranking like the ISS Quality Score for governance, with the 10th decile being the lowest quality E&S practices and highest risk. Scores are re-evaluated on an ongoing basis with current events being considered for any possible score changes.
Bloomberg covers more than 13,000 companies in its ESG data collection universe. It compiles public ESG information disclosed by companies through corporate social responsibility (CSR) or sustainability reports, annual reports and websites, and other public sources, as well as through direct contact with the company.
While other providers rate companies on ESG risks or ESG profile relative to peers. Bloomberg scores firms based on ESG disclosure transparency using a scale from 0-100. The score is based on 800 different metrics that cover all aspects of ESG disclosure. The more information disclosed, the higher the score. Despite the different scoring focus, Bloomberg offers in its terminal third-party ESG ratings from ISS, RobecoSam, Sustainalytics and CPD Climate scores.
There are several other ESG ratings providers that we have not covered here that are worth investigating: RepRisk, Thomson Reuters, Corporate Knights Global and Dow Jones Sustainability to name a few.
The surge of ESG capital has raised the importance of these companies. While some investment advisors can perform in-house ESG analysis, many do not have the budget and must rely on ratings providers to evaluate companies’ ESG performance. Investors need ratings that are accurate and represent reliable assessments of companies’ ESG risk and management. As a result, it is important to consider some of the critiques of these ratings.
According to a research report by the American Council for Capital Formation, some problems with ESG ratings include inconsistent methodologies across providers leading to uncorrelated scores, lack of standardization and auditing of ESG reporting, company size bias (large caps tend to be awarded higher ratings), geographic bias (companies in the US tend to receive inaccurate scores) and failure to identify risks.
It is worth noting that companies with higher ratings by ESG rating firms tend to receive a larger share of the ESG capital pool. As a result, it is critically important for the Investor Relations area to play an active role in this rating process in order to ensure ratings providers are using accurate and reliable information. It is equally important for IR professionals to be a voice for shareholders in the development of the methodologies these companies use.
Written by Mark Schwalenberg, CFA