ESG scoring and ratings – advantages and pitfalls

Companies that neglect the environmental and social impact of their businesses face clear financial risks. Any investor considering a long-term investment horizon needs assurance that a company’s business model won’t be undermined by climate change, that it manages its workforce with care, and that its use of resources is sustainable. This makes analysis of ESG factors an essential part of any credible investment strategy.

The problem is in how to assess those sustainability aspects. Companies can self-declare their sustainability approach, but investors have become increasingly alert to the phenomenon of greenwashing. Conducting independent ESG analysis is a labour-intensive and expensive business. It takes time to build internal expertise, and it is certainly not an option for smaller investment organisations with tighter budgets.

One solution to this issue has become external ESG ratings. The ESG rating industry has ballooned in recent years as investors come to rely on third-party providers to assess companies and funds on their ability to manage ESG risks. As sustainability disclosure requirements increase in Europe and elsewhere, rating agencies are becoming increasingly important for their specialist ability to digest and interpret new information.

Ratings are now provided by many major credit rating and financial analysis groups such as Morningstar, Bloomberg, Moody’s, MSCI and S&P Global. They provide ratings both for individual portfolio companies, such as Novo Nordisk or L’Oreal, as well as for some of the funds that invest in them.

Curbing complexity and confusion

However, ESG ratings are not necessarily a panacea. In February 2024, the European Union reached a provisional agreement on a proposal for rules governing rating agencies that evaluate the sustainability characteristics of companies and funds’ portfolios. This regulation proposal on ESG ratings is a tacit admission that in the absence of a common set of rules, rather than providing clarity for investors, the disparity of rating approaches has created complexity and confusion.

The EU’s regulation proposal on ESG Ratings is a tacit admission that in the absence of a common set of rules, rather than providing clarity for investors, the disparity of rating approaches has created complexity and confusion.

In proposing a first draft proposal in 2023, the European Commission observed: “The current ESG rating market suffers from deficiencies and is not functioning properly, with investors and rated entities’ needs regarding ESG ratings not being met and confidence in ratings undermined.”

Says Martin Moloney, secretary-general of the International Organization of Securities Commissions: “ESG ratings have become instrumental in guiding investment decisions, [but] undisclosed methodologies, hidden data sources and obscure evaluation processes compromise the very foundation of trust.”

The new rules, which will probably come into effect in 2026 or even 2027, would require rating agencies to disclose their methodologies, which must be approved by the European Securities and Markets Authority, in order to bring transparency and consistency to the market. The rules should also apply to financial institutions that provide ratings as part of their marketing. While the methods and data sources used by rating agencies may still vary from provider to provider, at least investors should have a greater ability to assess and understand how different firms’ ratings are arrived at.

Sustainability-related risks

Third-party ESG ratings can be used by individual and professional investors to understand the sustainability-related risks of investing in particular companies or funds. They are designed to provide an independent assessment and prevent companies and funds from ‘marking their own homework’ regarding their exposure to sustainability risks.

They are quite different from regulatory categories measuring the sustainability of companies or funds. Funds sold in Europe are required to be classified by their promoters under article 6, 8 or 9 of the Sustainable Finance Disclosure Regulation, depending on whether or not they have sustainability characteristics or a sustainability-linked purpose.

The approaches taken by rating agencies vary considerably. Some ESG fund ratings are largely qualitative, based on in-depth interviews with the fund manager and the sustainability team, delving into their process and the extent to which ESG is integrated into the day-to-day running of the portfolio. Others will simply look at the aggregate ratings of the underlying assets to come up with an overall score for the portfolio. Most of ESG funds mix both approaches.

Each is a valid approach, but can produce quite different outcomes. For example, with ratings that take an aggregate of individual company scores, there may be high- and low-scoring companies within the same fund. A wind farm may be balancing out a tobacco company or fuel retailer. On the other hand, more qualitative approaches are, by their nature, more subjective and may not reflect an individual investor’s personal sustainability views. The same goes for quantitative approaches, which might have undisclosed methodologies that do not reflect an investor’s personal views. Still, it is fair to say that qualitative approaches are subject to a less harmonized approach, as they do not follow a strict rating methodology and may vary significantly depending on who’s performing the review, on the surrounding circumstances, etc.

It’s important to be aware that some fund groups have ESG as well as corporate responsibility ratings.

It is important to be aware that fund groups may have ESG as well as corporate responsibility ratings. ESG ratings certify that a fund group is doing what it promises in analysing ESG risks, but responsibility ratings also consider aspects such as exclusion, sustainability and impact, and measure funds against these broader goals.

Corporate ESG ratings

With individual companies, there is also a difference in the extent to which rating agencies use qualitative and quantitative data to assess how much a company’s long-term profitability is exposed to risks arising from environmental, social impact and governance factors. Some agencies provide a company score; others just seek to provide standardised data for each company, leaving investors to make their own judgment.

Each agency takes a different approach and measures slightly different factors, and companies may end up with wide differences in scores depending on the provider. An often-cited example is auto manufacturer Tesla, which is highly rated by some agencies because of its pioneering role and leadership in the expanding electric car market. But others mark it down because of controversy over governance issues, including but not solely the outsized role played by founder, CEO and largest shareholder Elon Musk. In 2022 S&P Global dropped Tesla from the sustainable equivalent of the S&P 500 index, citing its poor handling of a federal investigation into the safety of its self-driving systems as well as allegations of poor working conditions at its factory in Fremont, California.

Since an ESG rating is drawn from the aggregation of multiple factors, an oil company with good corporate governance and employment practices could score highly, while a technology firm that denies shareholders effective oversight of its business or with a poor record on labour rights could do badly. Carbon emissions are only one element, which may lead to outcomes that investors do not expect.

It’s important to bear in mind the concept of materiality: rating agencies give weightings to environmental, social and governance factors according to how critical they assess the issue to be for the rated company. Weightings may vary according to the company’s size and sector – for  example, with banks, social impact and governance tend to be considered as being more important than environmental considerations. Each agency determines its own weightings, which explains how the same company can have very different aggregate scores depending on the importance given to a particular aspect by each agency.

The importance of information to investors

Ratings are imperfect, but they are nevertheless a critical type of information for investors. They provide an independent assessment of a company’s efforts to manage its sustainability risks, or a fund manager’s assessment of the risks inherent in its portfolio. Companies report that investors increasingly ask for their ESG ratings when making investment decisions.

Investors need to find the providers that best reflect their values and whose assessment they consider to be most robust, but work-around solutions are emerging. For example, some environmental groups are conducting their own ratings of rating agencies and offering guidance on which are worthwhile. Sustainability consultancy ERM publishes an annual assessment of ESG ratings based on the views of those who use them.

Ratings for funds and companies are likely to continue to grow in importance, and new legislation in the EU and elsewhere should help improve transparency around how assessments are carried out. In the meantime, investors should take time to identify providers whose work appears to be best aligned with their goals.