Jonathan Carlson/theispot

Improving the ESG Rating Landscape

by oscar contreras

oscar contreras is an economist in the Research Department at the Milken Institute, where he specializes in international finance and macroeconomics. This article is based on a more technical report by Claude Lopez, Oscar Contreras and Joseph Bendix.

Published November 16, 2020


It’s taken a while, but so-called ESG issues — short for environmental, social and governance issues — have become a priority for investors, spurring companies to up their game on social responsibility. Leading publicly traded firms are releasing more information about their ESG efforts. This trend, by the way, is particularly true for the S in ESG, as social issues ranging from race relations to pandemic consequences have crowded the headlines.

The Good News

Actually, ESG investing has been booming across the globe for some time, with both asset owners and managers increasingly incorporating ESG into their financial analyses and decisions. According to the Global Sustainable Investment Alliance (GSIA), an association that collects information across most of the affluent world, the value of assets under management with an explicit ESG mandate reached $30.7 trillion at the beginning of 2018. This represents an impressive 34 percent increase over 2016.

The level of commitment varies by country and region, but is pretty high in a lot of places. Investment strategies that incorporate ESG criteria now command a significant fraction of all professionally managed assets, ranging from about 18 percent in Japan to more than 50 percent in Canada, Australia and New Zealand.

In part, this trend reflects some investors’ desire to do good. But for many, it’s a matter of doing well by doing good: it pays to identify and manage ESG risks and opportunities that cannot be easily detected through standard financial analysis.

Reducing exposure to polluters or to companies with poor waste management policies, for example, can help mitigate regulatory risk. Similarly, screening for good social practices (such as a respectful workplace culture, human rights protection and corporate community engagement) can reduce exposure to scandals that could damage a company’s reputation. As Dan Hanson, former managing director at BlackRock (the world’s largest institutional money manager) summarizes it, “ESG is a proxy for risk that is not priced in, and companies that better manage these risks can deliver returns with greater certainty.”

But …

How do you know who’s walking the walk as well as talking the talk? Enter the private ESG rating agencies. By providing clear, cost-effective and consistent information about companies’ ESG performance, they can help investors pinpoint firms that meet their standards. Moreover, an independent assessment of a company’s ESG performance can also give the companies being rated the opportunity to differentiate themselves, creating bottom-line incentives to adopt better practices.

But is the information now provided by rating agencies in fact “clear, cost effective and consistent”? A recent survey conducted by Sustainalytics, a major ESG research provider, found that while many investors regularly rely on ratings to inform their decisions, they find them difficult to use and are sometimes frustrated by them. Inconsistencies and lack of comparability have proved particularly confusing. And this confusion has become a significant barrier to the adoption of ESG investing.

Who’s on First? 

Differences across ESG ratings can naturally emerge if the providers adopt different definitions of ESG performance. Some agencies, for example, may equate it with a company’s compliance with specific ethical standards — say, human rights standards. In contrast, others emphasize a company’s ability to manage financially material risks and opportunities arising from ESG factors.

The differences are understandable, given the subjective nature of ESG criteria. But more importantly, differences may reflect the need to satisfy investors and asset managers with different demands and motivations. Some investors, for instance, care a lot about the use of fossil fuels while others don’t care to notice. Thus, there’s no good reason for rating agencies to march in lockstep, but they do need to be clear about which ESG issues they prioritize and to what degree.

By providing clear, cost-effective and consistent information about companies’ ESG performance, rating agencies can help investors pinpoint firms that meet their standards.

That’s easier said than done. In a new report, my colleagues and I explore two additional reasons that can lead rating providers to score the same company differently:

Measurement. Rating agencies may disagree on how to measure the same ESG factor. Despite efforts by multiple standard-setting organizations, there is no universally accepted approach to measuring non-financial indicators. Rating agencies employ hundreds of ESG-related variables. Some come from company reports and regulatory filings and, therefore, should be consistent across agencies. But much of the input comes from interviews, questionnaires and third-party analyses that can diverge widely. And that leads us to another point.

Methodology. Even if agencies agree on how to measure different ESG-related factors, each ESG agency has developed its method to decide what ESG-related indicators to consider and how to aggregate them into an overall score.

Our research offers insights on improving the ESG rating landscape.

Improving the Data

First, there is a need for data standardization. In the absence of a structured framework to report and monitor firms’ ESG information, the burden lies on companies to communicate their initiatives and on investors to research them. New technologies, such as big data analysis and AI, can help process a larger set of information from different sources, including firms’ communication strategies and other alternative resources. However, there is a need to define a core set of variables that would capture these efforts as part of a long-term strategy. ESG rating agencies could then process this information and provide their assessment of the firms.

Harmonization would reduce the reporting burden on firms and increase the quality of the information collected. The use of standardized data would also lead to more comparable ratings. This would benefit both the firms being evaluated and the investors using these evaluations; it would lead to a clearer link between the information and its impact on the assessment. A firm could then decide the appropriate strategy to improve its rating (or not), and investors would understand the implications of the rating in terms of ESG risk management.

While several efforts — including a recent announcement by the “Big Four” accounting firms to create a common ESG reporting framework — are under way, it remains to be seen whether they will succeed. An important message from our research is that there are some dimensions, such as governance, for which something approaching consensus already exists.

More Transparency

The second implication of our research is the need for agencies to be transparent regarding the method they use in their ESG assessments. Are E, S and G factors equally important? Or does the rating focus mostly on one dimension? Each agency uses a different weighting system to create a single score, which can lead to different ratings even when using the same data.

Agencies do not have to agree on a single definition, any more than institutional investors have to agree on one. But every user of the rating should be able to see how the sausage is made.

• • •

Investors’ new focus on ESG coincides with the increasing understanding that, in an integrated global economy buffeted by poorly understood forces ranging from climate change to mass migration, there’s more to corporate success than making it good and making it cheap. But that recognition won’t do much good unless we devise practical ways to measure success and failure — and thus much depends on the capacity of rating agencies to tell us what we want to know and how they figured it out.