Business is booming.

Boom in ESG ratings leaves trail of confusion

There is a new gold rush under way in finance. It is not Wall Street bankers rushing for the latest big takeover deal or to list speculative acquisition vehicles.

It is the race to carve out market share in the very lucrative business of providing advice to investors on environmental, social and governance issues — particularly in the form of rating and ranking how companies fare on such factors.

It is being driven by the sheer weight of money flooding into ESG funds as issues such as climate change and sustainability move up the investor agenda. About $2.7tn of assets are now managed in more than 2,900 ESG funds, according to Morningstar. In the fourth quarter of last year alone, there were about $142.5bn of inflows into the sector.

A flourishing industry of ESG rating consultants has sprung up to assist these investors. Mike Zehetmayr, a specialist for EY on financial service risk and compliance technology, says his firm identified about 100 providers in October, double what it had found the year before.

Some of these rating services have been around for decades. Once a sleepy backwater of investment analysis, large investment data providers — such as MSCI, Refinitiv and Morningstar — grasped their opportunity by buying up smaller consultancies.

Such services can reduce research efforts by individual fund managers and investors to find worthwhile potential investments and flag problematic issues.

However, there is an emerging problem in the diversity of approaches and methods used by providers, all of which have their own theoretical biases. With so many consultants and methods around, it can distract some investors and make it harder to draw meaning from aggregate ratings and rankings. If a company scores highly on one ESG ranking but not another, what conclusions should an investor draw?

Academics at MIT Sloan School of Management say the lack of standardisation on ESG scoring sorely needs to be addressed, dubbing the problem “aggregate confusion” in a recent report. “First, it makes it difficult to evaluate the ESG performance of companies, funds and portfolios, which is the primary purpose of ESG ratings,” said Florian Berg, Julian Kölbel and Roberto Rigobon.

“Second, ESG rating divergence decreases companies’ incentives to improve their ESG performance. Companies receive mixed signals from rating agencies on which actions are expected and will be valued by the market. This might lead to under-investment in ESG improvement activities.” The researchers add that because of the dispersion of metrics and methods, markets are less likely to price companies on ESG performance and make it difficult to link executive remuneration to it.

The largest providers use teams of analysts to gather relevant hard data to then create ESG scores, and thereby rankings. Some groups such as All Street Sevva and Util in the UK deploy natural language processing of company documentation to provide assessments. But many larger rating groups rely primarily on annual financial reports.

This can be problematic. Emanuela Vartolomei, founder of All Street, points out that more than half of the 70,000 listed companies in its database do not address sustainability explicitly in their published literature.

Some systems also may not pick up on subtle changes within a company. Measuring for diversity on the basis of board member composition, for example, does not fully capture issues such as how inclusive a company is in treating staff, points out Johannes Lenhard, of the Max Planck Cambridge Centre for Ethics, Economy and Social Change.

While large investment management companies such as BlackRock may have the staff numbers to sift through data from external and internal evaluations, smaller managers have to limit their efforts.

Maria Lozovik, chief executive of Marsham Investment Management, says her firm has committed to finding “greening” companies. But she says she cannot rely on external sources, bemoaning how many of the largest raters use “black box” algorithms to screen for ESG issues and do not provide access to the backing data.

All this makes ESG investment managers a little nervous. Regulators throughout Europe and increasingly in the US want to know how ESG funds make up their portfolios. Probes by US and German regulators into “greenwashing” allegations against asset manager DWS would have sent shivers through some investment groups. DWS has denied the allegations.

Meanwhile, the companies themselves are overwhelmed with data access requests not only from ESG data providers and shareholders but also from other stakeholders such as suppliers and customers, says EY’s Zehetmayr. And corporates are wary lest they release any inappropriate data, miring them in controversies.

Zehetmayr thinks the formation under way now of the International Sustainability Standards Board by accounting rule setters could well reduce variability among ESG ratings. And investors are likely to become choosier on the ESG data they buy, encouraging more standardisation. That should spur consolidation in this growing industry.

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