The role of ESG ratings

Over the last few years we’ve seen a significant growth in the use of environmental, social and governance (ESG) ratings, particularly by investors.

14 Jan 2021 . 9 min read

In parallel, the ESG rating industry has grown considerably, already seeing a phase of consolidation and a new wave of competitors – often ESG data providers extending their services to compose ESG ratings as well – entering the market.

In this article we introduce the universe of ESG rating agencies and cover how such agencies arrive at their respective ESG ratings. We look at the relationship between credit and ESG ratings, discuss how ESG ratings need to evolve and outline the approach companies ought to take in order to harness the opportunities that come with ESG ratings while minimising potential negative outcomes.

The market of ESG rating agencies and data providers is fast evolving

According to the Global Initiative for Sustainability Ratings (GISR), there are well over 100 organisations that produce sustainability research and ratings on companies[1]. The leading ESG data companies include Bloomberg, MSCI, RepRisk, Sustainalytics and Thomson Reuters, while Vigeo Eiris, MSCI, GMI Ratings, 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. At the same time newer entrants are differentiating themselves by using big data, artificial intelligence and machine learning to evaluate companies on their ESG performance.

In addition to single ESG ratings, many agencies 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. The world’s largest provider of ESG Indexes is MSCI, which has created over 1,500 equity and fixed income indexes[2], designed to help institutional investors to integrate ESG or climate considerations in their investment process and portfolios. Segmented by different investment approaches – “Integration”, “Value & Screens” and “Impact” – investors can choose from solely climate change and/or low carbon focused benchmarks, social indexes such as for example the Women’s Leadership Impact Index or indexes that combine top corporate ESG performers; the MSCI ESG Universal Index is one example[3].

Finally, the sustainable finance market has also boosted the emergence of ESG data providers, often one division within an ESG rating agency, offering comprehensive ESG data in particular for institutional investors. ESG ratings agency Sustainalytics, for example, offers through its ESG research team ESG data that includes more than 220 ESG indicators and 450 fields and covers over 12,000 companies. The firm also recently introduced country ESG risk ratings for over 170 countries, based on more than 40 indicators[4].

The importance of ESG ratings and ESG in credit ratings

The rise of ESG rating agencies and the integration of ESG factors in credit ratings is a natural consequence of ESG considerations becoming mainstream in the investment world: When the UN-backed Principles for Responsible Investment (PRI) was launched in 2006, 63 investment companies with $6.5 trillion in assets under management (AUM) signed a commitment to incorporate ESG issues into their investment decisions. By April 2018, the number of signatories had risen to 1,715, representing $81.7 trillion in AUM[5]. In 2019, in FTSE Russell’s global investor survey, 77% of European asset owners expressed interest in applying ESG considerations – up from 44% in 2018[6].

With markets pricing ESG risk into corporate bonds – corporate issuers with a strong ESG focus, which helps minimise risks, have already shown to achieve better coupons[7] – and studies over recent years indicating that a strong ESG performance positively correlates with financial performance[8] make clear that ESG ratings and ESG scores as part of credit ratings can have a major impact for companies: not only could a low rating increase the price of a bond’s issuance, but it could also cause investors to exclude a company stock from their portfolios or could equally lead to index providers eliminating a company from their indexes if it were to fall below a certain ESG performance threshold.

The methodology behind it

But how exactly do ESG ratings work, and how do they differ from credit ratings, which in recent years have also integrated ESG factors? Generally speaking, ESG rating agencies calculate a composite score of individual ESG indicators for a company. This usually includes two steps: 1) Determining a set of material indicators that affect a company, such as its business model, the industry, and its geography 2) Each indicator – there can be up to 100 different indicators – is then assigned a weighting and score which helps to compute an overall ESG score.

Looking at the various ESG rating agencies, there are many differences in approach, in methodology and in nomenclature, which make ratings difficult to compare. For example, Sustainalytics’ ESG rating is an “absolute” numerical score measuring unmanaged ESG risk, composed of unmanageable ESG risks + manageable but unmanaged risks. As an absolute score, the rating can be compared across companies and industries. Similarly, Institutional Shareholder Services (ISS ESG) provides an absolute score that is expressed as a letter, A+ to D+, but does not deconstruct manageable risks.

The MSCI rating on the other hand is not absolute: a company’s ESG performance is reflected only relative to an industry or peer set, with a letter range of AAA to CCC, similar to credit ratings, expressing the overall rating.

These are only the most salient differences between these selected agencies, but there are many more. The following chart outlines further characteristics:

Source: ESG rating agencies company presentations

Unlike ESG ratings that opine on ESG factors exclusively, traditional credit ratings provide an opinion on credit quality and probability of default/loss given default. The rating scales of the main providers, S&P, Fitch and Moody’s, are expressed as letters (for example AAA to D for S&P and Fitch), making credit ratings more comparable. Increasingly credit ratings also incorporate ESG factors and risks, acknowledging ESG risks and opportunities have the potential to affect creditworthiness.

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.

While rating agencies and other ESG data providers, for example refinitiv, update ESG data usually once a year, any relevant ESG news about a company will be picked up immediately and, if significant, can lead to a swift adjustment in a firm’s ESG rating. In the event of severely negative ESG relevant news a company could be instantly excluded from ESG indices and funds[9].

Transparency and standardisation to improve reliability of ESG ratings

While credit ratings from different providers, as mentioned, are fairly easy to compare, ESG ratings from different providers can differ significantly. This is due to the fact that ESG rating agencies adopt different definitions of ESG performance and different approaches to measure it. 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, while another study[10] calculated a correlation of roughly just 0.3 between the two major rating agencies, Sustainalytics and MSCI. For comparison: credit ratings from Moody’s and S&P Global Ratings are correlated at 0.99[11].

Therefore, ESG ratings are receiving 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 standardisation 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[12].

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”[13]. 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[14].

Seeking the dialogue about ESG with rating agencies

Companies need to acknowledge the fact that their ESG ratings will be mainly driven by publicly available ESG information about their firm. This often means that the rating is not just influenced by the progress that a company makes in ESG, but whether that progress is communicated externally. Those not sharing their ESG ambitions, measures and, in particular, impacts will be penalised with a lower ESG rating. Given ESG disclosures are evolving rapidly and ESG ratings are generally reviewed annually, it is common for ratings reports to reflect data that may not be the latest.

Depending on levels of awareness, company size and the extent of pressure from investors, firms have been allocating differing levels of resources to manage their ESG ratings (see chart below) and to engage in active dialogue with agencies as otherwise those will try to find proxies if they don’t have access to relevant data.

So what should this engagement ideally look like? For companies it’s important to understand and meet the information requirements and rating approaches of the different agencies. For a start, focusing on two or three of the major ESG rating agencies is a realistic target. The key task lies in identifying the material drivers of a company’s ESG performance and “quick wins”, meaning ready data that supports its ESG narrative.

At the same time, businesses ought to embrace ESG ratings and the dialogue with rating agencies as a valuable internal benchmarking tool, provided by external, independent experts, to improve their sustainability performance and sustainability reporting, with ESG strengths and weaknesses/risks coming to light in the course of that process. It also offers an opportunity to compare a company’s ESG approach with that of its competitors and as such can be a powerful incentive for taking action.