Pros and cons of ESG ratings

08-18-2022
Pros and cons of ESG ratings

Methodologies vary among services

 

ESG ratings have become somewhat controversial. There are some who think they should be abolished altogether, and some who think they should be incorporated in every investment decision. Those in the abolish camp cite lack of consistency and lack of transparency as the main reasons. I’ve even read the claim that ESG ratings are going to kill ESG investing.

The other side of the argument is that ESG ratings provide a quantitative, relatively unbiased, means for comparison. The reality is that there are some real benefits to ESGs ratings but there are also some significant drawbacks. ESG ratings are not going to kill ESG investing; if anything kills ESG investing it will be greenwashing. And ratings are a tool against greenwashing. Let’s go through some of the deficiencies and some of the benefits in ESG ratings.

Deficiencies

We will start with some of the commonly stated deficiencies of ESG ratings, the first one being a lack of consistency. By this we mean that the scores can vary from one rating provider to another. This, of course, depends on different methodologies and how you’re looking at the data.

Some ratings providers show a rating based on the industry or sector of the company, so, for example, oil companies would be ranked only against oil companies. Others will show the universal ranking, where industry and sector doesn’t matter, so an oil company could be ranked against a tech company.

I think we need to move away from comparisons by sector. In the age of the climate crisis, oil and gas companies should not be getting better scores than solar companies.

The ESMA Report on Trends, Risks and Vulnerabilities No. 1, 2021 states that a study done on the ratings from five prominent data providers shows 60% correlation across ESG ratings. This naturally results in different index construction and different holdings for funds and ETFs tracking those indexes. Let’s take three ESG index-tracking ETFs as an example (see Table 1).

The underlying indexes are from S&P, MSCI, and Morningstar/Sustainalytics and all are focused on the U.S. market with ESG filters. Table 2 shows a snapshot of the top 10 holdings for each fund.

There is a lot of overlap, but there are also a few key differences. The highlighted companies do not belong to either of the other two funds. The one that really jumps out is Exxon Mobil in the S&P list. The key here is that the S&P 500 ESG Index targets 75% of the float market cap from each GICS industry group. In other words, there are a lot of companies from the energy industry in their ESG index. S&P publishes a list of exclusions consisting of any company with an ESG score in the bottom 25% of their industry group.

The MSCI index also targets companies with high ESG ratings in each sector and, like the S&P index, has a list of exclusions. One key exclusion is that any company with an MSCI ESG Controversies Score below 3 is not eligible. The Sustainalytics Index has a similar exclusion based on controversies, which might be why Exxon Mobil does not show up in their indexes. This leads to one of the other deficiencies in ESG ratings: the lack of transparency.

Ultimately, we don’t know exactly why Exxon is excluded from the MSCI or Sustainalytics indexes. In general, it’s usually easy to see how a company scored on each of the metrics, but it’s very hard to see the company-specific data that led to that score.

But, as an analogy, we don’t really know exactly why a company gets assigned to a certain sector either. Different data providers have different methodologies for sector classifications, and sector allocations are widely accepted.

Benefits

With ESG scores what we do get is very good methodology documents to the point where you can see all the factors that are being measured. And the fact that there are differences in the scores is not necessarily a bad thing. ESG investing means different thing to different investors, so the fact that we have a choice and can pick a methodology that aligns with our values should be seen as a positive.

The best attribute of ESG ratings is that they provide a simplified means for comparison, without them there is no way we could compare thousands of companies across the same metrics. The ratings are probably our best defense against greenwashing. Otherwise, we are left to read the lengthy reporting on climate solutions done by a company like Exxon Mobil that might make you think they are a carbon extraction company.

Or you could look at the ESG scores that measure real results and see how they compare to peers in their industry or against a global universe. Sustainalytics has Exxon rated as “High Risk” and ranks it in the top 25th percentile in their industry group (oil and gas producers), but they drop to the 83rd percentile when compared with the global universe that disregards industry. MSCI shows Exxon as “Average” in the integrated oil and gas industry, but states that it is “strongly misaligned with global climate goals” and says it is not an ESG Leader “on any of the Key Issues” evaluated for the industry.

The best approach to ESG ratings is to find a process that most closely aligns with your investing values or consider all the ESG ratings available and go with consensus. A company like OWL ESG uses the “wisdom of the crowd” approach where they gather data from over 500 sources, including the majority of the major ESG research firms. This results in ESG scores that reflect the consensus on a company.

Ultimately, ESG ratings are not perfect and should not be the only consideration when looking at a company or a fund through an ESG lens. But they are a valuable and necessary part of the process.

Reid Baker, CERA, ASA, is Vice President, Analytics and Data, at Fundata Canada Inc., a leading source for investment fund information,

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