Lately, ‘ESG’ has been heavily criticized as an empty buzzword. While this criticism can be largely traced back to ideological and political divisions, we feel that the scepticism is not entirely misplaced. Investors have grown dependent on ESG ratings as a tool to ‘measure’ the sustainability credentials of companies, but these ratings have well-known shortcomings and their validity as a proxy for corporate sustainability is questionable. The European Union (EU) recently announced that it will introduce regulation on ESG rating activities, aiming to boost investor confidence in sustainable products and reduce the risk of greenwashing. This is a welcome development, likely to improve transparency around the production of ESG ratings and increase accountability by bringing providers under the supervision of the European Securities and Markets Authorities (ESMA). Yet, the proposed regulation misses the opportunity to address the structural flaws of ESG ratings and we think that a more radical intervention would be warranted to strengthen the framework for sustainability ratings in line with the objectives of the EU Sustainable Finance Action Plan.
A booming industry…
Sustainable investing has gained massive traction in recent years. Asset managers globally are expected to increase their ESG-related assets under management (AuM) to more than EUR 30 trillion by 2026, and ESG assets are on pace to reach 21% of global AuM in less than 5 years . Against this background, the market for ESG data and ratings has been booming, with providers generating revenues of almost EUR 1 billion in 2021 alone. Publicly-listed companies have been reportedly spending on average between EUR 200,000 and 450,000 per year in ESG ratings-related costs, while institutional investors have been paying almost EUR 1 million for collecting, analyzing, and reporting ESG metrics. Europe – one of the most advanced jurisdictions on sustainable finance – accounts for 60% of global spending on ESG data.
This data has become increasingly central to the investment decision-making process. Respondents to a recent call for evidence issued by ESMA indicated that ESG ratings and/or ESG data products are used as inputs for EUR 3.8 trillion of investments (48% of respondents’ total AuM). As such, the firms who produce ESG ratings have come to wield major influence on investment decisions and capital allocation.
…with Structural Flaws
Investors have grown dependent on ESG ratings as a roadmap to navigate which companies are leaning towards sustainable practices. But the reliability of these scores as a proxy for corporate sustainability is significantly challenged by several structural flaws.
ESG ratings produced by different providers for the same company are inconsistent.
Using a pairwise correlation matrix, we undertook a comparative study of the individual ratings of each company in the S&P 500 produced by 4 different providers. By cross-referencing each rating with the other three, we calculated the (Pearson) correlation coefficients for each pair of ESG rating providers.
The results (figure 1) show noticeable discrepancies among the four ratings for the same company. While we did identify many cases where ratings for the same company from different providers fell in the same quartiles of the score distribution – indicating that the companies were evaluated similarly, in relative terms – the correlation coefficients remain below 0.7. Correlation between the ratings provided by S&P Global, Refinitiv and Bloomberg tend to be relatively higher (above 0.5), whereas Clarity AI’s ratings of SPX companies were quite dissimilar from the rest (figure 1).
Source: Algebris Investments based on Data from S&P Global, Bloomberg Finance L.P. Refinitiv and Clarity AI. Data as at 01/03/2023
Although the divergence in ESG ratings produced by different providers for the same company is a well-known fact, it is less clear where this divergence comes from. Berg et al. (2019) decompose the divergence into scope, weight, and measurement. They find that discrepancies are not due to different weighting of E/S/G factors, but to a fundamental disagreement about how the underlying factors are measured and evaluated. Different ESG rating providers appear to measure the performance of the same firm differently in given categories – particularly the very sensitive areas of Climate Risk Management, Product Safety, Corporate Governance, Corruption, and Environmental Management System. This measurement issue is problematic if the goal is to have ESG ratings based on objective observations that can be ascertained. Moreover, the authors also identify a ‘rater effect’ – namely, when a rating agency gives a company a good score in one category, it tends to give that company good scores in other categories too. This effect suggests that measurement divergence is not just noise, but that patterns influence how firms are assessed.
ESG ratings are not a good proxy for sustainability fundamentals and impact of a business.
A look at the correlation between ESG ratings and sustainability fundamentals suggests that investors should be cautious in interpreting ESG ratings as a proxy for the sustainability of a business. Figure 2 shows the correlation between the Environmental (E) scores of companies in the utilities sector against the same companies’ share of renewable energy out of total energy production. If the ratings were truly measuring the sustainability of a business, we would expect a strong positive correlation between these two variables – intuitively utilities that generate a larger share of energy from renewable sources are better aligned with net-zero objectives than those relying more on fossil fuels. But the correlation between the share of companies’ renewable energy production and their E score appears very weak in the data.
Source: Algebris Investments based on Data from S&P Global, Bloomberg Finance L.P. Refinitiv and Clarity AI. Data as at 01/03/2023
A proper evaluation of the sustainability credentials of emission-intensive sectors is key from a net zero transition perspective. While their main business activities are on average GHG intensive, utilities are key to the operation, deployment, and integration of clean energy sources and the renewal of power grids. For these companies, the existence of these trade-offs makes the internal accounting of environmental and social impacts particularly hard. Finally, where some utilities are government-owned, the transparency in their disclosure may be more challenging – reinforcing the need for investors to rely on expert third-party rating when evaluating sustainability from an investment perspective. Yet, the pairwise correlation of ESG ratings of utility companies from different providers is especially low (lowest among all GICS sectors, figure 3).
Source: Algebris Investments based on Data from S&P Global, Bloomberg Finance L.P. Refinitiv and Clarity AI. Data as at 01/03/2023
Most ESG ratings currently do not take a double materiality approach to sustainability.
Over the past few years, the EU regulatory framework has been embedding the concept of double materiality across both corporate and financial reporting. The EU Sustainable Finance Disclosure Regulation (SFDR) requires investors to disclose the adverse impacts of their investments on environment and society, while the EU Corporate Sustainability Reporting Directive (CSRD) will require companies to report both the impact of non-financial factors on their financials and the impact of the companies’ activities on the environment and society. These requirements will soon be anchored onto the European Sustainability Reporting Standards (ESRS), which will establish a reporting framework rooted on double materiality.
Most ESG ratings providers, however, do not apply a double materiality approach in their ratings. Of the providers surveyed in the previous section, only S&P Global explicitly takes a double materiality approach in their ESG score – “whereby a sustainability issue is considered to be material if it presents a significant impact on society or the environment and a significant impact on a company’s value drivers, competitive position, and long-term shareholder value creation”. Both MSCI and Sustainalytics – the two largest ESG rating firms globally – are clear in their methodology that their ESG scores are based on a single materiality approach, aimed at measuring only companies’ financial exposure to ESG risks.
In part, this is expression of a deeper transatlantic divide. In the US, the issue of sustainability disclosures is much more contentious than in Europe. The US Securities and Exchange Commission (SEC) released its proposed climate disclosure rules in March 2022, which would involve a single materiality approach and require US companies to provide information on climate risks their businesses are facing. This proposal has been controversial and the SEC has been delaying finalization, expected for spring 2024.
Europe was home to the pioneers in the space of ESG ratings, but the sector has undergone significant consolidation in recent years and many European firms have been acquired by US rating agencies. The ESMA call for evidence on ESG ratings shows that US firms MSCI and Sustainalytics are the two most frequently used ESG ratings and data providers. Given the different approaches to sustainability disclosures across the US and Europe, the US-centric geographical concentration of ESG rating firms and the over-reliance on US providers can become problematic from a European perspective.
ESG ratings risk being systematically biased against Small & Medium Enterprises (SME).
In principle, company sustainability and company size should display no meaningful correlation, as there is no obvious reason why a large business should be more “sustainable” than a small one. But when looking at ESG ratings, this correlation appears very clearly in the data. Figure 5 shows the median ESG rating for approximately 12’000 companies, broken down into deciles of market capitalization. Size clearly matters: the median score of the 10% largest companies by market capitalization is more than double the median scores of the 10% smallest companies in the sample.
Most ESG ratings providers opt for a questionnaire-based data collection, and commonly share the same approach to missing data – wherein they regard any unsubmitted information as a 0 score in the context of their rating calculations. This approach may easily result in a penalty for first-time responders – who may not yet have the capabilities to collect all data requested. This effect is exacerbated for smaller companies, who tend to have less resources and data gathering capabilities.
As such, SMEs may systematically receive low scores that are not representative of material ESG issues in their business, but rather of incomplete disclosure. Moreover, the ESG-rated companies that responded to the ESMA call for evidence highlighted lack of communication with ESG ratings providers. For unsolicited ratings, companies are not notified of the publication and only in limited cases can they provide feedback to the ESG rating providers, thus also undermining the opportunity to report errors when identified. Respondents also reported difficulties receiving objective reasons for the ratings assigned and noted that when the opportunity to report feedback is given, this is a slow, difficult, and lengthy process.
Against this background, we see a risk that an uninformed and unquestioning integration of ESG ratings in investment strategies could lead to capital misallocation at the aggregate level. In the attempt to reach a higher average ESG score for their portfolios, investors could divert capital away from (relatively less covered and relatively lower rated) SMEs, towards larger firms. Rather than enabling innovative and sustainability-focused SMEs to access a diversified pool of funding – a core objective of the EU Capital Market Union project – the current system could produce the opposite result.
Source: Algebris Investments based on data from S&P. Data as at 13/02/2024
It can be fixed
Under the EU Sustainable Finance Action Plan, the importance of sustainability assessments in investment decision-making is bound to grow further. It will be essential for investors to be able to rely on data and metrics offering a realistic representation of the sustainability credentials of investee companies.
Many expected that ESG ratings would serve this purpose, but at present this is not the case. ESG ratings produced by different providers for the same company are often inconsistent, and exhibit weak correlation with objective measures sustainability fundamentals (Philip Morris receiving a higher ESG rating than Tesla is one prominent, but by no means, isolated example). Lastly, ESG ratings may be systematically biased against smaller companies, hence introducing a risk of capital misallocation.
The proposed EU ESG ratings regulation introduces important safeguards. ESG ratings will need to obtain an authorization from ESMA or an endorsement by an EU authorized ESG rating provider. The discipline of potential conflicts of interest of ESG rating providers is strengthened, and so are transparency requirements for both the producers and the users of ESG ratings.
The regulation, however, stops short of prescribing minimum requirements for ESG ratings to be sold in Europe. While understanding the reluctance of EU authorities to interfere with the protection of intellectual property and the freedom of private companies to best structure their business model, we think this is a missed opportunity. Proprietary different methodologies in fact could be maintained but within a set of minimum requirements that ensures different rating systems still produce ESG ratings that are material and decision-useful without blurring the real sustainability credentials of companies.
In our view, ESG ratings providers should be required to use a double materiality approach for the ESG ratings they aim to sell in Europe. This would align ratings with the approach to corporate sustainability disclosures that the EU is taking with SFDR and CSRD. When they become available, we are of the view that data from CSRD disclosures should be used as the primary raw data inputs for ESG ratings to be sold in Europe. Moreover, the EU Principal Adverse Impact indicators (PAIs) should be integrated into the rating process – as it constitutes an intuitive framework to evaluate the “inside-out” element of double materiality, ie. the impact that a company has on non-financial factors.
ESG ratings providers should be allowed to retain full methodological control on how they would implement a double materiality approach and on how they would factor adverse impacts into their ratings. But the introduction of these minimum requirements would allow investors to rely on the ESG ratings as a proxy of corporate sustainability from a double materiality lens and the resulting ratings would be coherent with the goal of the EU Sustainable Finance Action Plan.
The EU regulation states that providers “should be encouraged” to address both aspects of the double materiality principle and should disclose whether they implement a double or single materiality approach, but it stops short of any prescription. As discussed above, however, transparency is only part of the problem and most ESG data providers already do disclose whether they implement a double or (more frequently) a single materiality approach. As such, mandating more transparency is unlikely to make a substantial difference in ensuring the reliability and decision-usefulness of these products.
Overall, leveraging a common rating methodology would enable a consensus over a realistic picture of corporate sustainability, yielding more value than the current system. As the risk of backlash against sustainability initiatives is growing – in part because of greenwashing concerns – we believe that strengthening the framework for sustainability ratings and assessments will be paramount to achieving the objectives that the EU has set for itself in the Sustainable Finance Action Plan.
Silvia Merler
Head of ESG & Policy Research
Iacopo Esposito
ESG Analyst
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