Ratings agencies come under ESG scrutiny

Martin Moloney, secretary general, IOSCO.

Ratings agencies in the environment, social and governance (ESG) space have once again come under scrutiny following recent comments by the International Organisation of Securities Commissions (IOSCO) secretary general Martin Maloney.  He voiced concerns that the sustainability market depended too heavily on their ESG findings although was optimistic that these issues would be resolved as the industry developed.

ESG ratings are used by individual investors and fund managers to guide investment strategies by understanding potential sustainability risks to business performance. Companies also employ ESG ratings as an internal benchmarking tool to help improve sustainability performance.

Speaking to the International Finance Law Review in mid-Jan, Maloney noted, that, “In a mature, well-serviced market, ratings are part of a broader market analysis and assessment process where information is combined and digested according to the investment appetites of customers.  We have too much reliance on ratings when it comes to ESG matters at the moment because that ecosystem of information, market analysts and ESG investment managers is only in its infancy.”

His comments follow on from ta report the international umbrella group published late last year – ESG Ratings and Data Products Providers- which called for greater oversight of ratings and data providers. It found a lack of clarity and standards as well as transparency about the methodologies underpinning ratings, and uneven coverage of sectors and geographies.

The IOSCO report also noted that “there may be concerns about the management of conflicts of interest where the ESG ratings and data products provider, or an entity closely associated with the provider, performs consulting services for companies that are the subject of these ESG ratings or data products.”

These are far from new issues, but they have become much more pressing at IOSCO as well as a plethora of other multinational trade groups, national and global regulators due to surging inflows. Research from Refinitiv Lipper show that a record $649 billion poured into ESG-focused funds worldwide from the beginning of 2021 until November 30. This was a large jump from the $542 billion in the same period in 2020 and $285 billion

One of the biggest problems is a lack of consistency in the metrics deployed which can lead to widely divergent and ambiguous scores, according to a new study by quant technologies provider SigTech.

Daniel Leveau, head of investor solutions at SigTech.

“The divergence is attributed to how the ratings agencies define and measure ESG performance,” said Daniel Leveau, head of investor solutions at SigTech. “Many of the criteria are hard to measure and assigning a rating for a specific criterion is often not as precise as using input from a firm’s financial statement. This ambiguity around ESG performance makes it hard to form a universal standard for ESG ratings.”

Underlying these problems is the varying quality of data, which academics at MIT Sloan labelled as “noisy.” The result is a divergence in ratings from the independent agencies that evaluate and assign ESG ratings to firms, according to Florian Berg, a research fellow working on the MIT Sloan Sustainability Initiative. He added that this in turn generates confusion and a much lower probability that ESG ratings have a direct correlation to financial performance, undermining their utility as an investment tool.

Berg, along with research affiliate Julian Koelbel and MIT Sloan professor Roberto Rigobon, published three papers on ESG ratings divergence and its impact. Using a common taxonomy and various mathematical modelling techniques, the MIT team fit the different rating agency approaches into a consistent framework to better understand the differences.

Among the key takeaways are that there are low correlations between the agencies. The research found that correlations among six prominent ratings agencies – KLD/MSCI Stats, Sustainalytics, Vigeo Eiris/Moody’s, RobecoSAM/S&P Global, Asset4/Refinitiv, and MSCI – was on average 0.61. By contrast, mainstream credit ratings from Moody’s and Standard & Poor’s are correlated at 0.99.

In addition, their findings suggest that ESG ratings do not properly reflect ESG performance, making it difficult for fund managers to identify outperformers and laggards. Moreover, divergence in ratings hampers the motivation of companies to improve their ESG performance, because there are mixed signals from ratings agencies about what to focus on and what is valued in the industry.

The academics pointed to three main factors driving these trends The first is Scope divergence whereby ratings are based on different attributes. This is when for example one agency includes carbon emissions or labour practices while another does not, Measurement divergence happens when agencies assess the same attributes, but employ different raw data while last but not least – weight divergence  – emerges when ESG ratings agencies take different views on the relative importance of attributes.

To improve the quality of ESG measurements, the MIT Sloan Sustainability Initiative has launched the Aggregate Confusion Project. The aim is to work with industry partners to gather data, solicit feedback, and create a set of best practices for use by ESG ratings providers as well as the companies reporting corporate social responsibility data for disclosure purposes.

Maloney said he is also “quite hopeful” that the problems IOSCO highlighted in its report will be eventually addressed partly because many of submissions it received in the consultation process showed “an industry grappling with change rather than in denial”.

“Regulators and the industry should press the ESG ratings sector to work towards consistency of practices across all their ratings work,” he said. “In a sense, we are knocking on an open door with the industry on this one.”

This does not mean complete uniformity though. IOSCO said that as a global organisation it acknowledges regulation will differ depending on the jurisdictions.

©Markets Media Europe 2022

Deutsche Bank tightens vendor sustainability requirements

Deutsche Bank is tightening its sustainability requirements for vendors and suppliers across the world and...

London Stock Exchange Group acquires MayStreet

London Stock Exchange Group (LSEG) has signed an agreement to acquire MayStreet, a US-based...

Gemspring acquires GoldenSource

Gemspring Capital, a middle-market private equity firm,  has acquired GoldenSource, a provider of enterprise...

Deutsche Bank tightens vendor sustainability requirements

Deutsche Bank is tightening its sustainability requirements for vendors and suppliers across the world and...

London Stock Exchange Group acquires MayStreet

London Stock Exchange Group (LSEG) has signed an agreement to acquire MayStreet, a US-based...

Gemspring acquires GoldenSource

Gemspring Capital, a middle-market private equity firm,  has acquired GoldenSource, a provider of enterprise...