The boom in ESG ratings is confusing

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A new gold rush is underway in finance. It’s not Wall Street bankers rushing for the latest big buyout or listing speculative acquisition vehicles.

It’s a race to carve out market share in the highly lucrative business of advising investors on environmental, social and governance issues – particularly in the form of rating and ranking how companies do well on these factors.

He is driven by the sheer weight of money flowing into ESG funds as issues such as climate change and sustainability increasingly feature on investors’ agendas. About $2.7 billion in assets are now managed across more than 2,900 ESG funds, according to Morningstar. In the fourth quarter of last year alone, there were around $142.5 billion in inflows into the sector.

A thriving industry of ESG rating consultants has sprung up to help these investors. Mike Zehetmayr, EY’s financial services risk and compliance technology specialist, says his firm identified about 100 vendors in October, double what it had found the previous year.

Some of these rating services have been around for decades. Once a sleepy backwater of investment analysis, big investment data providers – such as MSCI, Refinitiv and Morningstar – seized their opportunity by buying up smaller advisory firms.

Such services can reduce the research efforts of fund managers and individual investors to find attractive potential investments and report problematic issues.

However, there is an emerging problem in the diversity of approaches and methods used by providers, all of which have their own theoretical biases. With so many consultants and methods, it can distract some investors and make it harder to make sense of aggregate ratings and rankings. If a company scores high on one ESG ranking but not on another, what conclusions should an investor draw?

Academics at MIT Sloan School of Management say the lack of standardization in ESG scoring needs to be addressed, calling the problem “global confusion” in a recent report. “First, it makes it difficult to assess the ESG performance of companies, funds and portfolios, which is the primary purpose of ESG ratings,” said Florian Berg, Julian Kölbel and Roberto Rigobon.

“Second, divergent ESG ratings reduce the incentives for companies to improve their ESG performance. Companies are getting mixed signals from rating agencies on which actions are expected and will be priced by the market. This could lead to underinvestment in ESG improvement activities. The researchers add that due to the dispersion of metrics and methods, markets are less likely to rate companies on ESG performance and make it difficult to tie executive compensation to it.

The largest suppliers use teams of analysts to collect relevant hard data to then create ESG scores, and therefore rankings. Some groups such as All Street Sevva and Util in the UK are deploying natural language processing of company documentation to provide ratings. But many large rating groups rely primarily on annual financial reports.

This can be problematic. Emanuela Vartolomei, founder of All Street, points out that more than half of the 70,000 companies listed in her database do not explicitly address sustainability in their publications.

Some systems may also not pick up on subtle changes within a business. Measuring diversity on the basis of the composition of board members, for example, does not fully take into account issues such as how inclusive a company is in its treatment of staff, points out Johannes Lenhard of the Max Planck Cambridge Center for Ethics, Economy and Social Change.

While large investment management firms such as BlackRock may have the manpower to sift through data from external and internal ratings, smaller managers must limit their efforts.

Maria Lozovik, managing director of Marsham Investment Management, says her firm is committed to finding “green” companies. But she says she can’t rely on outside sources, lamenting how many of the biggest evaluators use “black box” algorithms to detect ESG issues and don’t provide access to supporting data.

All of this makes ESG investment managers a little nervous. Regulators across Europe and increasingly in the US want to know how ESG funds compose their portfolios. Investigations by US and German regulators into “green money laundering” allegations against asset manager DWS have reportedly sent shivers down the spine of some investment groups. DWS denied the allegations.

Meanwhile, companies themselves are inundated with data access requests not only from ESG data providers and shareholders, but also from other stakeholders such as suppliers and customers, says EY’s Zehetmayr. And companies fear releasing inappropriate data, miring them in controversy.

Zehetmayr thinks the ongoing formation of the International Sustainability Standards Board by accounting policymakers may well reduce variability in ESG ratings. And investors are likely to become more discerning about the ESG data they buy, encouraging greater standardization. This should spur consolidation in this growing industry.

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