Regulators and politicians are focusing on the accuracy, transparency and potential for conflicts of interest with sustainability scores
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The sector has since been transformed. ESG ratings now influence, and in some cases dictate, which stocks and bonds make it into the $2.8tn of investment funds that are, according to Morningstar, marketed as sustainable. Its products lend legitimacy to the companies and investors who claim to be helping hit the Paris Agreement goal of limiting global warming to well below 2C above pre-industrial levels.
The European Commission said in June that potential conflicts of interest plague ESG data giants in three areas: the sale of ratings, data and indices to the same investor clients; the sale of consultancy services to help companies improve their ratings; and the practice of charging companies to display their own rating on financial products.
There is a further potential problem for the industry — the gap between the perception of what ESG ratings assess and what they actually demonstrate. The scores are not designed to measure corporate performance on carbon emissions or pollution. Instead, the raters measure how well a company is managing environmental, social and governance risks to their own bottom line, for example from hurricanes or carbon taxes.
The other large players include the London Stock Exchange Group, proxy adviser ISS, Morningstar and credit rating agencies S&P Global and Moody’s. “Only two or three ESG providers in the end matter,” he says. “They will de facto determine what ESG is and all investors will follow.” Will Ballard, head of equities at Border to Coast, which manages UK government pension schemes, raises concerns about data sent to him and other clients by MSCI. Larger companies and those who interacted “frequently”, more than 10 times, with MSCI, were both more likely to have a high ESG rating, the research showed.
Matt Moscardi, a former executive director at MSCI, remembers being summoned to the offices of Goldman Sachs when he was head of ratings for financial institutions to face criticism about the score the US investment bank had received. “They had a roomful of people and I was effectively on my own.” There was also a “fair share of arguments with companies”, who “didn’t care for the ratings”. While these complaints by companies being rated were mostly fielded through other teams, analysts were aware of them.
To counter the possibility of analysts coming under emotional or legal pressure from companies they rate, the biggest providers have increasingly tried to prevent them from speaking directly to the companies. Basing scores on algorithmic analysis of controversies and risk, and on publicly available information, can minimise the chance of bias creeping in, according to executives in the industry.
An increasingly popular product sold by the top agencies, so-called “temperature ratings”, measure what warming trajectory for the planet the company’s actions align with. These can be “totally misleading”, Pederson says. “Intuitively you think it tells you something about whether the company is behaving in a way that is commensurate with climate change, or good or bad for the environment,” says Pederson. “The rating providers historically have not done enough to disabuse the public of that impression.”Given the different pressures they face from regulators, with growing sceptcism in the US about net zero, some companies might be forced to choose which side of the Atlantic they wish to prioritise.
A flurry of reporting requirements being introduced by the EU and the US will widen the pool of available data on everything from pesticide use to carbon emissions, adding complexity to the task of rating agencies.
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