ESG ratings and data: From misalignments to global standards

Environmental, social, and governance (ESG) ratings have risen in importance as a disclosure tool and are often used to promote issuers and products using individual and aggregated scores. While they’ve been a focus for marketing (e.g., firm X has a AA ESG rating), many investment firms rely in a more limited way on ratings as a direct input to their investment process. While we believe they can provide unique sustainability-focused insight, their proliferation and widely disparate results have raised questions about their utility.

To be sure, there are good reasons for these differences, which we address below. But because the differences among ESG ratings aren’t well understood by issuers, asset managers, investors, and other market stakeholders, we think it’s important to discuss why they’re different as a prelude to discussing how they should be used and how this field should develop.

ESG ratings are different by design

Over the last 10 to 15 years, mainstream financial information providers have expanded into the market for providing ESG data and ratings, devising new methodologies for assessing issuers’ ESG strength and weakness. By and large, these efforts have adapted conventional sounding terms, including “ratings” and “index,” and common scoring notations, such as letter grades for individual issuers and strategy-level assessments. While the impulse to streamline the communication of ESG strength and weakness has been helpful, it has also led to some misunderstanding. One major point of confusion concerns their difference relative to credit ratings.

Credit ratings are issued by regulated credit rating agencies (CRAs) and have been an integral part of capital markets for decades that are focused on one thing: assessing the creditworthiness of a borrower in general terms or with respect to a specific debt instrument. A high credit rating indicates that borrowers are likely to repay their debt without any issues, while a poor credit rating suggests that borrowers might struggle to make their payments. 

ESG ratings, by contrast, purport to provide some measure of ESG performance or risk and are often not comparable with each other. Some ratings combine dozens of issues spanning human rights and the environment under one rating, while others weigh climate and environmental risk ahead of other issues; still, others draw from corporate controversies reported in the media. A company that achieves a high ESG rating for its environmental performance according to one provider may receive a lower ESG rating from another provider on the basis of its governance practices.

The CFA Institute compared the two most closely aligned ESG ratings and two standard CRAs to show how these differ in correlation, demonstrating that ESG ratings can be designed for different purposes.

Moreover, ESG rating providers are, unlike CRAs, unregulated at this point in time, so don’t benefit from the same rigor in terms of quality control and oversight. That said, we could be on the cusp of change as the U.K. government recently announced a consultation to consider regulating ESG ratings providers.

Although they’re designed with different materiality models and use cases in mind, we note that approaches to rating construction are similar. Most rating shops gather raw datasets from company voluntary and regulatory disclosures, may make estimates about performance when data is lacking, and apply quantitative and qualitative assessments ranging from best practice, peer comparison, and year-on-year progress to gauge performance. Finally, they construct subscores that eventually have weights assigned and are aggregated into a final score.

The lack of alignment in ESG ratings is only a good thing if rating providers clarify what their ratings are optimized to measure, and if users like asset managers and investors understand what they’re looking at. Some ratings, for example, focus on providing information about financially material issues and may be suitable for ESG risk analysis,  but aren’t intended for identifying positive ESG impacts or opportunities. Different ratings offer different tools with different applications; bringing them into alignment isn’t always possible or even a goal worth pursuing. Using them effectively requires deep understanding of their various strengths and weaknesses, and selecting the right tool for the job.

Factors driving differences in ratings

Each of the dozens of ESG ratings and data providers constructs its products—individual company scores, indexes, and risk management tools—with different resources and end users in mind. We see variations in company coverage, ESG factor inputs, and data update frequency, among other differences. Providers vary in their rating methodology, how well they’re navigating inconsistent disclosure standards, and their fundamental definition of materiality. 

Although baseline ESG data has grown exponentially over the last two decades, in some cases it still cannot provide us the answers we’re looking for as asset managers. In the case of credit ratings, the data can give us the probability of credit default in the future. But in the case of health and safety data, for example, the available data falls short of giving us a well-defined probability of workers having accidents in the future. It’s fundamentally difficult to find the data needed to make genuine forecasts about performance.  

Methodology

Some providers are transparent about how they derive their ratings to both end users and input providers (issuers), while others hold their exact methodology closer to the vest. Some provide raw data only (therefore, should not be considered a rating provider); others mix and match raw data and relative rankings; while others only provide scores and ratings. Additional areas of methodological differentiation include:

• Risk weightings. Risk weightings assigned across ESG factors vary. Some providers equal-weight risk factors; others take a different approach. Some also make risk weightings more dynamic in order to reflect changing investor expectations and understanding of ESG risk over the course of time.
• Directedness. ESG ratings may be driven by industry exposure to key risk factors or company-specific exposures and actions.
• Data collection universe. Providers can incorporate a wide array of data in their ratings calculations. Hence data availability, access, and quality will underpin all ratings. In addition, modeling and estimating processes to fill data gaps can similarly skew conclusions on risk exposures.
• Data normalization process. Some ratings shops have a strict data normalization process where the environmental data on the numerator has to have the same scope of coverage and periodicity alignment as the financial indicator on the denominator, and some don’t.
• Update frequency. Some data can be updated easily; other data can have substantial lags. Ease and timeliness of refreshed data points can have a substantial impact on the current applicability of ESG ratings.
• Sector considerations  Differences in industry sector categorization used—such as Global Industry Classification Standard or Sustainable Industry Classification System—can drive further differences in peer company selection for relative ranking.
• Regional bias. Some ratings have country or regional biases embedded in their approach, such as for a governance issue like executive compensation. These may be addressed or corrected, or not.
  
  

Global standards

While thousands of issuers have been voluntarily reporting ESG data using standards such as the Global Reporting Initiative Sustainability Reporting Standards, the Sustainable Accounting Standards Board Standards, and the Task Force on Climate-related Financial Disclosures (TCFD) Framework for years, the lack of a global policy outlining expectations for corporate ESG practices in general, along with a patchwork of mandatory disclosure frameworks across hundreds of jurisdictions, contributes to challenges with consistency and comparability of ESG data.

Most companies struggle to understand the convoluted mapping of interconnected ratings, questionnaires, voluntary standards, and mandated disclosure protocols. The lack of a globally applicable reporting framework often results in disparate disclosures and inconsistent reporting. This can make it difficult to compare ESG efforts between firms and even within the same firm year over year. The advent of the International Sustainability Standards Board (ISSB) is a welcome development that will, over time, help standardize issuer reporting for financial markets purposes.

Factors affecting comparability include:

• ESG regulatory context. Markets vary in terms of the ESG standards their issuers are  subjected to. For example, certain levels of pollution may be allowed in some jurisdictions, while in others there are lower thresholds for illegality and noncompliance, as well as disincentives such as fines and legal action. While a company might be going beyond compliance in one jurisdiction, it may be lagging in another.
• Disclosure standards. The level of sustainability disclosures by issuers varies widely across sectors, industry peer groups, and geographies and remains largely voluntary.
• Size bias. Company disclosures of ESG data vary across the capitalization spectrum. Given the generally higher availability of resources among larger companies, larger-cap segments tend to have more robust disclosure. ESG ratings, by extension, can reflect this size bias.
• Coverage differences. Ratings providers don’t apply the same level of attention across all areas of all markets. Typically, their conclusions pertain to select areas of market focus and resource mobilization.

Materiality

Information is financially material if omitting, misstating, or obscuring it could reasonably be expected to influence investor decisions. Defining this in the ESG context can be challenging and unstandardized across sectors and regions. ESG ratings firms uniquely define material issues, which are then reflected in their scores, indexes, and other products.

Considerations related to materiality determination include:

• Factor focus. Providers take different approaches to factor analysis, considering some more or less material than others, which may be reflected in a company’s overall rating.
• Materiality boundaries. Providers may vary in their approach to defining the scope of materiality, including whether material issues in the value chain are relevant to consider for a company’s rating. In addition, the scope of materiality is open to interpretation (e.g., whether material factors should be limited to contemporary, established financially material ESG issues or treated more broadly to cover future-state financial materiality of social and environmental risks). Materiality could also be geographic in nature. For example, beverage producers in Southeast Asia may have higher financial risk stemming from access to fresh water than a beverage company in Canada.
• Risk/opportunity. ESG issues may be considered on a scale of risk, but may also be considered on a scale of opportunity. Ratings providers approach this dimension of ESG materiality in widely divergent ways.

Differences in ESG ratings create opportunity

As an active asset manager, ESG ratings are just one input of many that we use in our day-to-day analysis and portfolio management. Our aim in using them is to enhance our understanding of what companies are doing in terms of sustainability, what types of ESG risks they’re exposed to, and the degree to which they’re taking advantage of ESG-related opportunities.

In practice, therefore, we employ ESG ratings from multiple providers to varying degrees; in general, they’re inputs in our efforts to discuss topics with investment teams pertaining to new or ongoing ESG risks associated with issuers and the action we should take. In addition, we use the underlying data sets (rather than ratings) to understand all the relevant dimensions of risk and opportunity for thematic sustainable investing strategies, impact investing, stewardship activities, and ESG integration.

Overall, when we consider ESG ratings, we’re looking for extreme or surprising scores and then seek to understand what’s driving these results and identify issues for further research. These extreme cases of misalignment between ratings can be due to backward-looking data or can be forward-looking assessments of companies’ potential sustainability performance. But it’s only after doing further research—especially when we combine insight around misalignments with our direct engagement with company management—that we’re able to draw conclusions from outlier scores.

What’s next for ESG ratings?

ESG ratings by necessity constitute an innovative and rapidly evolving space. But like any newer assessment  system that relies on rapidly developing standards, the resulting ratings should be assessed with great care and conclusions should only be drawn after an assessment of the underlying drivers. There’s a clear need for investment firms to be able to communicate easily digestible ESG information to their clients; however, simplicity can be the enemy of accuracy and we anticipate that institutional investors will like to see a range of ESG data points to understand their portfolios.

On the other hand, there are many investment disciplines that have their own evolving or timeworn investment techniques for assessing the intrinsic valuation of an investment. ESG ratings and proprietary sustainability analysis are no different. The wide variety of ratings and methodologies is a reflection of the rapidity of innovation and the diversity of ways investors are integrating ESG factors into their investment analysis and approach.

We believe that the evolution of disclosure standards, including work from the TCFD, standards development at the ISSB, and the forthcoming disclosure standard from the Taskforce on Nature-related Financial Disclosures, is likely to improve the variety and quality of underlying ESG data sets. In our view, this will help boost the quality of different ESG ratings systems, but it likely won’t change the need for active judgment when it comes to understanding the full spectrum of ESG risk and opportunity.

Regulatory oversight of ESG ratings

As we look ahead to the evolution of sustainable investing in capital markets over the mid and longer terms, we see increased levels of mandatory ESG disclosure for issuers, better defined sustainable asset classes, and more signals of a maturing sustainable finance market. These will all support the continuous evolution of data and ratings services.

As the regulatory environment evolves in this space, several principles stand out to us that could help make ratings more credible and useful.

• Consistency: Effective disclosure regulation will require industrywide alignment on definitions and use of standards
• Quality: In concert with regulatory development, data quality should improve as well. This means enhancing the quantitative accuracy, assurability, and comparability of ESG data, as well as the quality of underlying ratings methodologies
• Utility: We would also hope to see a renewed focus around stating the objectives of specific ratings, together with a disclosure of ratings track records that demonstrate how a provider has delivered on their objectives over time

Although we agree that ESG data and ratings could benefit from regulatory oversight, it’s an open question under whose authority they should sit and how far regulation should go. As Sustainable Finance Disclosure Regulation requirements in Europe continue to tighten and define the market, the need for data to help investors, issuers, and others grows to ensure alignment and compliance. The European Securities and Markets Authority recommended that the European Commission implement specific product requirements for ESG ratings agencies and data providers—yet that requirement shouldn’t be the same level of “prescriptiveness” as those applicable to credit ratings. The aforementioned consultation announced by the U.K. government will similarly seek to establish ground rules for transparency and comparability of ESG data and ratings methodologies, but may fall short of being prescriptive for this disclosure type. We believe the emphasis should be on ensuring ESG ratings and assessments are based on up to date, reliable, and transparent data sources, as well as developed according to robust methodologies that are transparent and open to challenge by investors.