The role of ESG rating agencies and ESG data providers
The ESG rating industry has grown considerably over the past ten years and has already seen a phase of consolidation as well as a new wave of competitors entering the market – often ESG data providers extending their services to also include ratings.
According to the Global Initiative for Sustainability Rankings (GISR), there are well over 100 organisations that produce sustainability research and ratings on companies. The leading ESG data companies include Bloomberg, MSCI, RepRisk, Sustainalytics and Thomson Reuters, while Vigeo Eiris, MSCI, ISS ESG, Inrate and Sustainalytics count to the top 10 ESG rating agencies.
In a bid to secure a footing in the lucrative ESG ratings markets, credit rating companies S&P Global bought RobecoSAM’s ESG ratings business, while its biggest rival, Moody’s, acquired a majority stake of Vigeo Eiris last year.
How do ESG ratings work? Based on a composite score of individual ESG indicators, ranging from 70 to 1,000 different indicators with each weighting differently, they provide an overall rating of a company’s ESG performance.
In addition to single ESG ratings, many agencies also produce ESG-themed indices, such as for example the Dow Jones Sustainability Index (DJSI) or the FTSE4Good Index, which include companies that meet certain ESG thresholds.
Contrary to credit ratings, which issuers request and where credit relevant information is collated through a number of interviews and discussions with the company before a rating is published, ESG ratings are in most cases unsolicited. ESG rating agencies typically make their evaluations based on publicly available information, on corporate sustainability reports and on information from corporate websites. Some agencies will also send questionnaires to firms and offer companies to review and comment on profiles before finalising them.
However, ESG ratings from different providers have shown to diverge significantly. This isn’t necessarily surprising, considering that ESG rating agencies adopt different definitions of ESG performance and different approaches to measure it. The issue is, that the divergence is significant: an MIT study found that in a dataset of five ESG rating agencies, correlations between scores on 823 companies were on average a fairly low 0.61. For comparison: credit ratings from Moody’s and S&P Global Ratings are correlated at 0.99.
Hence, ESG ratings have received very mixed reviews. Critics point out that discrepancies in measuring ESG performance make it very difficult for investors to correctly identify ESG leaders and laggards. Likewise, different rating approaches cause confusion amongst companies, which are receiving mixed signals about what good ESG performance looks like. Finally, there’s also concern that there’ll be companies that know how to tell their ESG story, without evidence of the fundamentals, and equally there will be firms that haven’t yet succeeded in showcasing their ESG credentials in an impactful manner.
To find a reliable measure of ESG performance in an unregulated market, efforts are being made to bring more transparency and standardization to the ESG ratings industry. In July 2019, the European Securities and Markets Authority (ESMA) published technical advice on sustainability considerations in the credit rating market and guidelines on the disclosure requirements applicable to credit ratings around whether ESG factors were a key driver of the credit rating action – as this will allow the users of ratings to better assess where ESG factors are affecting credit rating actions.
At the same time ESMA chair, Steven Maijoor, called for regulating the ESG ratings market, pointing out that “the lack of clarity on the methodologies underpinning those scoring mechanisms and their diversity does not contribute to enabling investors to effectively compare investments which are marketed as sustainable.”
ESMA has now established the Coordination Network on Sustainability (CNS), which will be responsible for the development of policy in the area of sustainable investing, with a strategic view on issues related to integrating sustainability considerations into financial regulation.
Corporate clients who would like to discuss this topic further should contact Dr Arthur Krebbers, Head of Sustainable Finance, Corporates or, Varun Sarda, Head of ESG Advisory.