Close Close

Portfolio > Portfolio Construction > ESG

How to Understand ESG Ratings

Your article was successfully shared with the contacts you provided.

The proliferation of investments based on environmental, social and governance factors has led to multiple measures of related corporate behavior, which can be problematic for financial advisors serving clients who want to invest in sustainable assets. How can they assess with confidence the ESG rating of any one company or fund and compare it to the ESG rating of another company or fund with different ESG metrics of varying quality?

Advisors have another incentive to understand and compare ESG ratings. According to Morningstar and Barron’s, U.S. funds with high sustainability ratings tend to perform better than funds with lower ratings. In addition, TruValue Labs and Quantopian found that a portfolio of companies in the S&P 500 scoring high on their ESG Insight and ESG Momentum Scores outperformed the benchmark index over a five-year period.

But there are issues with ESG data. Close to 70% of institutional asset owners surveyed by Morgan Stanley recently said that lack of quality ESG data is one of their biggest challenges when investing according to ESG principles. Nearly 60% reported they did not have access to adequate tools to assess how investments align with their sustainability goals.

“There is no common standard for ESG reporting due to self-reporting by companies and data content providers each having their own ranking system in place,” reports Celent, a research and consulting firm focused on financial services technology, in a recent study. The study reviewed some of the leading data content providers for ESG, and found that some use a “controversy score” that can offset corporate self-reporting, which allows companies to cherry pick their best data. Advisors can use this information as a guide when assessing ESG reports from other data providers not included in the Celent report. Here are some report highlights:

Thomson Reuters. A database on more than 7,000 companies across the globe, including 1,000 for whom the data goes back about 15 years or so, based on corporate sustainability reports, annual reports and websites; SEC filings, NGO websites and news sources. Corporate self-reported data is classified according to 10 themes, including emissions and human rights that are discounted for significant ESG controversies.

The Reuters database is an open platform that can share propriety data and engage with partners such as TruValue Labs, an AI-powered ESG data provider.

Morningstar. Company-level data is provided by Sustainalytics, 40% of which was acquired by Morningstar last year. Sustainalytics measures three factors — preparedness (policies in place), disclosure (relative to regulation and/or global standards) and performance (qualitative and quantitative) — plus a quantitative controversy scored based on scanning thousands of media sources, industry reports and more.

ESG scores range from 0 to 100; controversy scores from 0 to 5, and Sustainalytics then normalizes scores across sectors.

Morningstar then does an asset-weighted rollup of company ESG scores with deductions for holdings with controversies when 50% of a portfolio’s assets have corporate ESG scores. It calculates sustainability ratings for over 38,000 managed products including ETFs, mutual funds, SMAs for equity and corporate bonds and collective investment trusts.

For a fund to receive a sustainability rating, at least 10 funds in a particular Morningstar category must have a sustainability score.

Morningstar recently added an asset-weighted carbon risk score for portfolios where 67% of assets have a Sustainalytics carbon risk score. It uses 70 carbon fund-level metrics including low-carbon designation.

FactSet. OpenFactset allows clients to buy individual data feeds on ESG reporting, including TruValue Labs and Reprisk. FactSet also has its own proprietary data feeds having acquired Revere Data in 2013 for supply chain data. Clients can learn if supplier is on a sanctions list.

Engaged Tracking. This London-based firm publishes carbon rankings of the world’s largest companies and their supply chains, covering over 4,000 companies and 30,000 securities. The carbon ratings measure Scope 1 (self-reporting by company), Scope 2 (energy emissions) and Scope 3 (everything else such as upstream and downstream activities for oil and gas companies).

Bernice Napach is the senior writer at Reach Bernice at [email protected]m.