Variability in ESG ratings makes a murky picture for investors

Different methodologies and ratings scales can cast the same security in a slightly different light

The recent removal of Tesla from the S&P 500 ESG Index – and the retention of ExxonMobil – was an example of how broad the perception on ESG ratings and scores can be.

Following that decision, and Elon Musk’s retort on Twitter, there was a flood of media coverage to point out the irony of an electric car company being booted and an oil company remaining.

S&P carefully articulated the reasons for change when it rebalanced the index, but it was clear some observers objected to the measure. Ark Invest founder and CEO Cathie Wood, for example, responded by tweeting: “Ridiculous. Not worthy of any other response.”

There are numerous companies in the US providing ESG ratings for public issuances, and the methodologies and scores they provide can vary significantly. This means that one company can be viewed differently among data providers – or even if the company is evaluated similarly by them, the ratings scales they use might be incomparable.

“This has been a reckoning that’s been coming for a while. Ambiguity around ESG ratings in particular has created some of the greenwashing we’ve been seeing over the past year or two,” said Kent McClanahan, vice-president of responsible investing at RBC Wealth Management.

“If you’re looking at a rating, what does a ’10’ mean? … What does a ‘AAA’ mean from another?”

The lack of correlation, use of different methodologies and scores has led to a murkiness that has made financial advisers “reluctant to go all in” on ESG, he said.

“What’s truly important is subjective to the ratings provider,” he added.

Wealth shops have to assess fund providers’ use of ESG ratings, with many relying on MSCI or Sustainalytics, the major players in the US.

“It’s not necessarily that one or other is right or wrong. It’s more about trying to understand the process they use to look at the information,” McClanahan said. “It requires a pretty extensive due diligence process.”

Different takes on securities

Using Exxon Mobil and Tesla as examples, it becomes clear that ratings firms differ on scoring.

Sustainalytics has an ESG risk rating for Exxon of 36.5, indicating “high risk,” less than a score of 40 on its scale, which demarcates “severe” risk. Tesla, by comparison, comes in on the higher side of “medium risk,” with a score of 28.5 (high risk starts at 30).

S&P rates Exxon with an ESG score of 36 out of 100, noting a low availability of data from the oil company. S&P’s score for Tesla, meanwhile, is 28, with a medium amount of data being available.

At the same time, ISS gives the company an ESG corporate rating of C-, a governance quality score of 4 out of 10 and a sustainable development goals (SDG) impact rating of 16.4 on a scale of -10 to 10, indicating “significant negative impact,” according to the firm.

ISS gives Tesla an ESG corporate rating of C+, a governance quality score of 10 and an SDG impact rating of -4.7.

Another rater, Moody’s Investors Service, gives Exxon Mobil an ESG credit impact score of 3, which is “moderately negative,” as well as an E-5 “very highly negative” environmental score, an S-5 “very highly negative” social score and a G-2, or “neutral-to-low” governance rating.

By comparison, Moody’s rated Tesla more favorably, with an ESG credit impact score of 2, as well as an E-2, S-3 and G-3.

A recent report from S&P firm Crisil analyzed ESG ratings from third party providers for more than 400 companies globally, finding an average correlation in their scores of 0.34.

Researchers have also noted that ratings firms can change their methodologies, leading to different retroactive scores for securities.

Interpretation is key

Among more than a dozen vendors that provide ESG ratings, the dominant ones used by fund companies are MSCI and Sustainalytics, said Wendy Cromwell, head of sustainable investment at Wellington Management, in an interview with ESG Clarity earlier this year.

“The work that those two companies and the whole broader group of vendors is doing is good work and is additive to the ecosystem. It’s the interpretation that can be problematic,” Cromwell said.

“A lot of people like to think of those ratings as being like credit ratings, meaning, Moody’s, S&P, they’re basically giving you the same information. It’s an agreed-on set of data and interpretation. And instead of thinking of those [ESG] ratings as credit ratings, we suggest that people think of them as sell-side recommendations.”

Investment firms, for example, would not be expected to have the same price target or earnings per share estimate for the same company, she noted.

“Would you work with them and take on their research reports to inform your own mosaic and help you think through how you would want to think about them and what questions you should ask those companies? Yes,” she said. “They have a different emphasis, but they can both kind of contribute to a greater understanding of a company and using the underlying data in a way that’s effective.”

Where are we going?

The regulation of ESG in the US is in the very early stages, and sources said they did not expect new rules for ratings providers anytime soon, much less encourage that. But in Europe, where the lack of consistency in ratings has been well documented, a push for guidelines has been in the works.

Late last year, the International Organization of Securities Commission issued a report on ESG ratings and data providers, recommending ways to improve reliability and transparency, and address conflicts of interest.

That group proposed regulators outline “good practices in corporate governance to help ensure appropriate independence and objectivity.” This included recommendations that ratings firms disclose potential conflicts of interest, describe how they get their data and whether they offer a way for firms to file complaints.

How firms use ratings

Many investment managers use third-party ESG ratings for securities in their portfolios. But some companies rely more heavily on in-house ESG expertise, using third-party ratings to supplement their data.

“We do our own proprietary analysis of ESG in every case. And then we will use those [third-party] ratings just to see if we’ve missed anything,” said Ron Temple, co-head of multi-asset and head of US equity at Lazard, in a recent interview with ESG Clarity.

“A lot of clients require one of the standard reporting numbers. But we do not rely on that for the investment decision making, because our sense is they don’t have the ability to do the materiality assessment that we can do. They don’t have the context.”

When Lazard’s ESG analysis differs from third-party reports, the company goes into meetings with clients prepared to explain why, Temple said. When portfolio managers see the company’s own analysis differing significantly from that of a ratings firm, they reassess the data and evaluate that they determined to be important or unimportant, he said.

“We’ve actually found in many cases that it basically gives the client more confidence that we really are doing the work that we told them we’re doing,” he said. “Our PMs are really good about making sure that when they go to the client quarterly update they’re aware, especially in our sustainable strategies, [that] you can tell this is a conversation we’ve had.”

Bigger issue for smaller companies

One area where ratings can differ substantially is in the assessment of smaller companies, said Josh Bennett, chief operating officer and senior portfolio manager at Weatherbie Capital, in a recent interview with ESG Clarity.

When engaging with small-and mid-cap companies to address shortcomings in their ESG ratings, Bennett and Weatherbie CIO George Dai often work with the general council at those businesses, they said.

“There isn’t yet an ESG team at most of these companies. So they’re not even aware of the difference, for example, between a Sustainalytics rating and an MSCI rating, let alone the 12 others that they could be looking at,” Bennett said.

In cases where companies’ disclosures or practices appear to be misrepresented in scores, they contact the ratings agencies.

In addition to using data from Sustainalytics and MSCI, Weatherbie is testing a service from FactSet’s Truvalue Labs, Bennett said.

“It has an interesting kind of spin on things in that it ignores what the company says about itself. And instead look at what the world is saying about this company,” he said.

Andrew Malk, founder and executive chair at Malk Partners, noted public equity investors face more of a challenge in getting complete, reliable data than private equity companies.

“It’s a challenge to get your arms around how strong ESG performance is of a public company,” Malk said.

More consistency in ratings “is needed, but it’s very challenging,” he said.

“In the case of, say, Telsa, how do you reconcile the contribution of essentially revolutionizing a form of transportation, with some concerning failures in their operations? I don’t have the answer to that, but the ESG community needs to keep grappling with the concept of materiality across these issues.”

Looking back

“The biggest issue with the ratings is that almost all of it is backwards looking,” RBC’s McClanahan said. “If we’re trying to invest, how do you look at something that’s forward looking?”

Improved access to data will lead to more opportunities for alpha, such as by identifying new areas for ESG integration, he said. Currently, the Securities and Exchange Commission is working on a final version of a rule for ESG risk disclosures for public companies.

The International Sustainability Standards Board’s recently proposed standards for sustainability standards and climate-related disclosure requirements could also help, and as a consequence of more consistent data, ESG ratings agencies will function more like sell-side agents, he said.

“It’s an industry that needs to grow up, and it is doing that right now, in front of our eyes,” McClanahan added.