Critics of environmental, social and governance fund ratings often cite numerous reasons as to why the ratings lack validity. While the ratings aren’t perfect, we explore some of the reasons why we believe they are worthwhile and how they may continue to improve.
Rating ESG Funds
One common argument regarding the validity of ESG ratings is that there are hundreds of ESG data, analytics and research providers, and that their scores are sometimes conflicting, making it difficult to draw conclusions. The reality is that there are only a handful of prominent ESG research firms, most notably Sustainalytics and MSCI.
These firms have long played an important role in gathering and assessing information about companies’ ESG practices. This has been and remains a considerable challenge. Company disclosures on ESG practices have always been voluntary, are rarely audited, and are not standardized.
But the quality and quantity of ESG data continue to evolve and improve. And, as companies realize that risks to their brands and reputations could harm their social license to operate, they are increasingly disclosing their ESG practices. In fact, in 2011, only 20% of companies in the S&P 500 published a sustainability report, increasing to 86% in 2018.
Investigating Reported Data
Criticizing the ratings requires an assumption that ESG ratings providers simply take ESG data reported by companies at face value, with no further investigation. This is simply not true.
Rather, these ESG research firms employ hundreds of sector-focused analysts who have expertise in evaluating and contextualizing ESG data. These analysts take company-reported data sets, along with data collected by machine learning and natural language processing from a variety of industry, nonprofit and news sources, and assess it in the context of that particular company and its industry. This analysis is necessary in order to determine the extent to which company policies, programs, and ESG performance meet industry best practices, and to measure the operational, legal and reputational risks posed to companies.
MSCI and Sustainalytics regularly communicate with the companies they assess, offering companies the opportunity to provide feedback on their assessments on an annual basis. The global response rate from companies is close to 80%, a number which has increased significantly in recent years as sustainability has emerged as a key focus area for corporations.
The development of ESG ratings systems has significantly contributed to the growth of sustainable investing. Only within the last few years have many asset managers moved to conduct this research themselves, leveraging third-party ESG research as a complement to their processes. As the integration of ESG issues in the investment process becomes more sophisticated, it becomes the user of the data’s responsibility to build on these insights, using them as a starting point.
Each asset manager has their own view on materiality and their own investment approach. The onus is on the manager to build a system and framework for considering these factors and supporting it with a sound rationale and investment thesis. We treat company-reported price-to-earnings ratios differently based on investment styles. We build our own valuation models that incorporate multiple data inputs that we adjust for various considerations. Why should the treatment of ESG data be any different? The secret sauce should be the application of the data, not the data itself.
Standardizing the Data and Ratings System
Alongside the increase in availability and quantity of ESG data, there is also a movement toward standardizing the data and ratings systems. To that end, the Sustainability Accounting Standards Board (SASB), the Task Force for Climate Related Financial Disclosures (TCFD), and others are working toward standardizing company disclosures, which will improve the quality of the data and create a common language for how companies report these metrics.
Generally Accepted Accounting Principles (GAAP) were established in 1933. Modern Portfolio Theory took hold in 1952. The Capital Asset Pricing Model came along in the 1960s. Our standard approaches for risk and return are still relatively new — and imperfect. ESG research and ratings should be viewed through the same lens. At best, we have a decade of data, and there are gaps in that data. It’s easy for investors to expect companies to disclose, be transparent and wait until the data improves. But if you do that, you’re leaving some really interesting data sets on the table that could provide valuable insights.
Our world is changing. Continuing to rely on traditional ways of evaluating risk and return just isn’t going to cut it. We need to continue to critically examine ESG data, ratings and integration techniques, but approach such scrutiny with context and through the lens of indicative and emerging evidence.
Kiley Miller is an associate portfolio manager working with impact portfolios at Envestnet.