ESG RatingsInsightsENJune 23, 2022by Madhavan NampoothiriESG Ratings – A Primer

ESG Ratings are the bedrock of sustainable investing. ESG Ratings or Scores are used not only by investors but also by other stakeholders to assess the Corporate Sustainability Performance(CSP) of the rated firms. But unlike corporate credit ratings which are highly correlated among different providers, ESG ratings are not homogenous and come in different forms. In this article, we attempt to understand ESG ratings, their raters(or ESG rating agencies),  ESG calculation methodologies, some of the criticisms and suggestions offered by the stakeholders to improve the credibility of the ratings. This 4-part Primer starts with the analysis of a controversy.

Part 1 – Tesla’s ESG conundrum

On May 17th 2022, Tesla was excluded from the S&P 500 ESG Index. This exclusion, which was part of the annual “rebalancing of” the S&P ESG Index, triggered immediate widespread extreme reactions from various stakeholders. 

Elon Musk, CEO of Tesla, was naturally outraged and called ESG a scam and tweeted a meme that said that ESG score is a metric of compliance with the leftist agenda, whatever that means. Given his recent harsh criticism of democrats, whose policies were responsible for Tesla’s survival and growth, Musk’s tweets of outrage were seen by some as a means of endearing himself to right-wing politicians and politicizing ESG further. For example, Mike Pence, a prospective Republican Presidential candidate for 2024, used the exclusion of Tesla from the S&P 500 ESG Index to argue in the Wall Street Journal that ESG scores are “inherently political, subjective and hypocritical”.

Interestingly, non-political stakeholders were also perplexed by Tesla’s exclusion but Exxon Mobil’s inclusion in the index. It did not seem fair that Tesla, which showed the path to decarbonizing the transportation sector, which accounts for about 25% of energy-related CO2 emissions, was excluded. Still, Exxon Mobil, which supplies products responsible for most of the transportation sector’s emissions, was included in the ESG index.

Anticipating questions about Tesla’s exclusion, S&P DJI’s Senior Director preemptively provided some answers. One reason was that while Tesla’s ESG score was stable over the previous year, other industry peers increased their ESG scores during the same period, thereby reducing Tesla’s ESG relative ranking. 

A few other things negatively impacted Tesla’s decline and included:

  • A lack of low carbon strategy (environmental aspect).
  • Lack of codes of business conduct (governance aspect).
  • Claims of racial discrimination and poor working conditions at a Tesla factory (social aspect).
  • It’s handling of investigations related to deaths and injuries linked to its autopilot vehicles.

The bottomline was that “while Tesla may be playing its part in taking fuel-powered cars off the road, it has fallen behind its peers when examined through a wider ESG lens” (read S&P’s note here). 

Interestingly, Sustainalytics, one of S&P’s rival ESG rating providers, concurred with S&P’s reasoning. In a note, Morningstar, which owns Sustainalytics, noted that while Tesla was doing well on the Environmental dimension, it was falling short of the other two dimensions of ESG – Social and Governance, and provided examples of the same (read the full commentary here). 

There have been suggestions in the past to break up the term ESG, which tries to measure too many things(like a conglomerate) and spin-off its initials – E, S and G(read more here). Given that different sets of investors have different priorities, this suggestion has merit. After the Tesla exclusion, calls have also risen for “Standalone Climate Ratings”. 

To understand how Tesla compares with other ESG providers, we analyzed the ESG performance of four ESG rating providers, all of whom share the ESG ratings/scores of several companies for free to the public. The table below provides the comparison.

    Rating  
Rating Agency Rating Type E S G Overall Ranking among industry peers
Refinitiv ESG Score 71 57 61 63 57 among 233 peer companies
S&P ESG Score 30 20 32 28 Not Available
Sustainalytics Risk Rating 28.5 42 among 83 peer companies
MSCI ESG Rating A “Average” among 42 peer companies

How does one make sense of these disparate data? That is at the heart of the problem for ESG practitioners. Each ESG rating provider follows a different rating methodology with varying data points taken for consideration and different weightings given to various topics. Some provide adjusted absolute scores, while others offer a relative grading. While one ESG score is industry agnostic, another rating is specific to a sector. One must understand the rating methodology to make sense of a rating. But before that, let us look at ESG rating’s evolution.

Part 2 – The ESG ratings providers’ landscape

While the term “ESG” was first mentioned in a 2005 UN PRI report called “Who Cares Wins“, the US-based firm KLD Research & Analytics Inc had started providing social and environmental performance data for a limited number of companies as early as 1991. Dutch firm Sustainalytics is another prominent example of pioneering ESG rating providers. 

As the interest in socially responsible investing, which morphed into ESG investing, grew, the need for actionable data related to the non-financial performance of a business also grew. Naturally, the number of ESG rating providers increased drastically, and SustainAbility, an ERM group company, came up with a “Rate the Raters” report in 2010 to compare these rating providers. In its 2020 “Rate the Raters” report, SustainAbility reported that more than 600 ESG ratings and rankings existed globally in 2018 and continued to grow (read the report here).

As with any other industry, the ESG rating industry has also consolidated, with several smaller niche ESG rating providers getting acquired by the more prominent players, including Bloomberg. The 2020 “Rate the Raters” report provides an excellent overview of the Mergers and Acquisitions(M&A) of ESG rating providers during the last decade(read here). In addition, while several ESG ratings providers are standalone firms, large entities like the “Big Three Credit Rating Agencies” (Fitch, S&P and Moody’s) also emerged as formidable ESG rating providers. 

According to a recent report by Opimas, the global market for ESG data surpassed US$ 1 Billion in 2021, and 3 players – MSCI, ISS ESG and Sustainalytics – account for about 60% of the market(read the report here). 

Below is a brief overview of some of the most prominent ESG rating firms.

Name  Headquarters Coverage (# of Companies)  Website
1 Arabesque London 7,000+  https://www.esgbook.com/
2 Bloomberg ESG Data Service New York City 11,800 + https://www.bloomberg.com/professional/dataset/global-environmental-social-governance-data/#:
3 Carbon Disclosure Project (CDP) London 13,000+ https://www.cdp.net/en/companies/companies-scores
4 Ecovadis Paris 90,000+ https://ecovadis.com/about-us/
5 Fitch New York City Not Available https://www.sustainablefitch.com/products/esg-ratings/
6 FTSE Russel London 7,200+ https://www.ftserussell.com/data/sustainability-and-esg-data/esg-ratings
7 Institutional Shareholder Services (ISS) New York City Not Available https://www.issgovernance.com/esg/ratings/
8 MSCI  New York City 8,500+ https://www.msci.com/our-solutions/esg-investing/esg-ratings
9 Moody’s New York City 5,000+ https://esg.moodys.io/
10 Refinitiv London 11,800+ https://www.refinitiv.com/en/sustainable-finance/esg-scores
11 RepRisk Zurich 205,500+ https://www.reprisk.com/solutions#the-esg-risk-platform
12 S&P New York City 8,000 https://www.spglobal.com/esg/solutions/data-intelligence-esg-scores
13 Sustainalytics Amsterdam 12,400+ https://www.sustainalytics.com/esg-ratings

In the next part, we will look at the methodologies of some of these ESG ratings providers. 

Part 3 –ESG rating methodology – A cross-comparison

In part 1 of this series, we observed that the different rating providers provided very different ESG ratings. While S&P and Refinitiv had ESG scores, MSCI had an industry-specific ESG rating on a scale (AAA to CCC). Sustainalytics had an entirely different rating in the form of ESG risk rating. In this section, we touch upon the methodologies of these 4 ESG rating providers and understand if they all have something in common. We chose these four rating providers since they also provide access to ESG ratings of several companies for free. 

1. MSCI 

MSCI provides its ESG rating to a firm following a 6-step process that involves Data, Metrics, Key Issues, Themes, Pillars and a company ESG rating. 

  • Data – 1000+ data points
  • Metrics – 80 material exposure metrics, 150 policy/program metrics, 20 performance metrics, 100+ Governance metrics
  • Key Issues – 35 issues for each industry and weighted based on materiality
  • Themes – 10 (4 on Environmental, four on Social and two on Governance) 
  • Pillars – 3 (Environmental, Social and Governance) 
  • ESG Rating – on a 7-point scale (AAA to CCC)
    • AAA and AA – Leader
    • A, BBB, BB – Average 
    • B and CCC – Laggard.  

The full MSCI methodology is available here

2. S&P 

Unlike MSCI, S&P calculates an absolute score after giving sufficient weightage to industry and other relevant factors. S&P follows the following steps.

  • 1,000 data points collected
  • 130+ questions answered based on weighted data point scores (up to 50% industry-specific)
  • 30+ Criteria Scores based on weighted question scores – 61 industry-specific approaches, with tailored questions, criteria and relative weightings.
  • 3 Dimension scores (Environmental, Social and Governance) were calculated based on weighted criteria scores (Adjusted for corporate ESG controversies).
  • 1 S&P Global ESG score is calculated as a sum of the weighted dimension (E, S and G) scores.

The detailed S&P methodology can be accessed here

3. Refinitiv

Refinitiv also uses a bottom-top approach to build a single ESG score. The steps are

  • Start with ESG Metrics – 630+ data points, ratios and analytics.
  • Aggregate ESG measures – 186 comparable measures from the 630+ data points used in ESG scoring 
  • Grouping these 186 measures into ten categories
  • Roll up the category scores into three pillars (relative sum of category weights which varies per industry for the environmental and social categories)
  • The final single ESG score is calculated using appropriate weights for the three pillars(E, S and G)

The full Refinitiv methodology is available here

4. Sustainalytics

Sustainalytics follows a different approach and methodology to calculate its “ESG risk rating”. The approach measures risk and what percentage of that risk is actively managed. In other words, the rating has two dimensions – Risk Exposure and Risk Management. Risk for a company is split into two components – Manageable risks and Unmanageable risks. The next part is to estimate how much of the manageable risk is being managed and how much is unmanaged. The unmanaged risk is the management gap, and the ESG risk rating is the sum of the management gap and the unmanageable risk. Put another way, 

  • Total Exposure Risk = Manageable risks + Unmanageable risks 
  • Manageable Risk = Managed risk + Unmanaged risk 
  • Management gap = Manageable risk – Managed risk = Unmanaged risk 
  • ESG Risk rating = Management Gap + Unmanageable risk 

Sustainalytics has five risk categories which are absolute and comparable across sectors. 

  1. Negligible (Overall Score of 0-9.99 points)
  2. Low (10-19.99 points)
  3. Medium (20-29.99 points)
  4. High (30-39.99 points)
  5. Severe (40 and higher points)

Read the ESG risk rating methodology of Sustainalytics here

Comparison of the methodologies

Comparing the ratings and their methodologies confirms what the practitioners have been complaining about the ESG ratings – the lack of convergence. Given that these ratings measure different things using different scales, even an apples-to-apples comparison is a challenge. 

For example, Sustainalytics provides a risk rating (the lower, the better) on a numeric scale after considering industry-specific issues. MSCI does a relative grading or rating for a firm within an industry (the higher, the better). This could be converted to a percentile score within that industry, but that percentile score of a firm cannot be meaningfully compared to the score of a firm in another industry. 

S&P, on the other hand, provides an absolute numeric ESG score (the higher, the better) after giving weightage to industry-specific factors, which makes it more amenable for comparing firms in two different industries. It is still subjective and depends on the weightage assigned by S&P. Refinitiv scores take an approach similar to S&P but probably start with a different set of data points and topics. This is just an illustrative example that compares only 4 ESG ratings, and the results will be similar if other ESG ratings are included in this comparison. 

In the next part, we will examine the magnitude of divergence of these ratings and some of the reasons for the divergence. Some of the areas where the ESG ratings converge will also be examined.

Part 4 – ESG rating – Divergence and Convergence

One academic paper involving MIT Sloan researchers reported that the correlations among six rating agencies (KLD/MSCI Stats, Sustainalytics, Vigeo Eiris/Moody’s, RobecoSAM/S&P Global, Asset4/Refinitiv, and MSCI) ranged from 0.38 and 0.71, with an average of 0.61. This is quite different from the correlation between credit ratings from Moody’s and Standard & Poor’s, which stood at 0.99.

Another analysis showed that the best correlation between two ESG ratings (Sustainalytics and S&P) of 400 firms in 24 sectors stood at 65%, which was much less than the 96% correlation between the debt ratings of Moody’s and S&P for the same set of firms(more here). 

The MIT research mentioned earlier came up with the conclusion that three factors were driving the rating divergence

  • Measurement divergence 
  • Scope divergence
  • Weights divergence

The research paper can be downloaded here. Given the wide range of ESG scores, investors like Danske Bank developed their own ESG rating methodologies for their own use. To reduce the divergence and improve the quality of ESG measurement and decision-making in the financial sector, the MIT Sloan School started “The Aggregate Confusion Project”. 

Recognizing the importance of quality ESG data and the need to increase the trust in ESG ratings, the International Organization of Securities Commissions(IOSCO), which is the global forum for securities regulators like SEC, has recommended that more transparency regarding the ESG rating methodologies is ensured by the ESG ratings and data providers(read here and here). 

While divergence of ratings is one major challenge for users of these ratings, there are some commonalities among these ratings. These include the size of a firm and the country of domicile of a firm (developed vs emerging markets). One of the academic articles examined Thomson Reuters ASSET4 ESG ratings and found that the size of a company influences its ESG ratings – the larger a company, the higher its ESG rating tends to be. Trym Riksen, Head of Portfolio Management at Gabler AS, found that large companies typically have higher ESG ratings from at least 5 ESG rating agencies(MSCI, Sustainalytics, S&P, ISS and CDP). He also noted that firms in Developed markets tended to have higher ESG ratings than firms in Emerging markets, and the size effect was prevalent within these groups(Developed markets and Emerging markets)(read the analysis here).

Conclusion

Corporate ESG ratings are necessary for responsible investors to make informed capital allocation decisions and other stakeholders to assess the non-financial performance of a firm. While there are hundreds of rating agencies, there is considerable divergence in ratings even among the top ESG rating agencies due to the data used and methodological differences. There are efforts from academia and regulators to improve data quality and transparency in ESG ratings.

About NordESG

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