The ESG Ratings they measure and the challenge of standardization

ESG investment, which incorporates environmental, social and governance criteria into quantitative analyses, is one of the trends with the longest international experience in recent years. According to a Global Sustainable Investment Alliance report, at the beginning of 2020 a total of 35.3 trillion of assets under management or, in other words, more than a third of total global investment, it corresponded to sustainable investment.

As ESG investment grows, so do the mantras about its transformative potential (which cannot seem to be refuted) and the number of critics who do not seem to believe their purpose (apparently full of good intentions). Thus, the ESG investment sector still has certain controversies behind it, and there are not a few who are skeptical about its true capacity to generate a positive impact on the society in which we live.

So,What is the right way to integrate considerations regarding the protection of the environment or the well-being of employees in investment strategies? And how is it possible to differentiate the companies that are more responsible in their operations from those that are not?

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The translation of sustainability into financial terms

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Just as credit risk ratings assess the solvency and future outlook of companies from an exclusively financial point of view, ESG ratings are aimed at analyze their performance based on environmental, social and governance criteria.

However, in the face of the controversies in which the sector is frequently involved, such as accusations of Greenwashing or the lack of consideration of certain negative externalities of the evaluated companies, it is necessary to define in depth the objective and scope of these ratings.

According to the definition of MSCI, one of the leading international rating agencies, ESG ratings measure the long-term resilience of a company in the face of sectoral risks in the environmental, social and governance fields.

Following the methodology of Sustainalytics, another of the leading agencies in the sector, these evaluations are based on the premise that the world is in transition to an increasingly sustainable economy, and that companies with more effective management of ESG risks will have greater value in the long term.

Thus, the main ESG ratings do not focus on the impact that a company has on its environment, but rather they evaluate the risk in financial terms derived from the management of those most relevant social, environmental and governance aspects (or materials) for each company.

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Causes and controversies associated with the lack of correlation

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With the proliferation of ESG ratings, lack of standardization around a common evaluation framework has given rise to growing skepticism regarding the validity and practical application of ESG ratings. In fact, According to studies from the prestigious MIT Sloan business school, the correlation coefficient between the ESG ratings of 6 of the most prominent global rating agencies is 0.61 (on a scale of -1 to 1); while the correlation between the credit ratings of agencies such as Moody's and Standard & Poor's increases to 0.99.

Following up with the results of MIT Sloan, this divergence is mainly due to two issues:

• First, the use of different metrics to evaluate the same aspect environmental, social or governance is the main cause of divergence between different assessments. Thus, the same attribute (such as gender diversity) can be evaluated with quantitative metrics (such as the percentage of women in the workforce, in management positions or in relation to the total number of new hires), based on qualitative metrics (such as ongoing equality policies and initiatives) or with a combination of both.
• On the other hand, the scope of evaluations it also plays a significant role in explaining the existing lack of correlation. Mainly, this is because different methodologies may involve the analysis of different ESG aspects, resulting in certain topics (for example, participation in activities of lobby) may affect a specific rating and not others.

To a much lesser extent, these lack of correlation are due to differences in evaluating the materiality of ESG criteria in the same company or sector; or, in other words, to the fact that different rating agencies do not follow the same criteria regarding the relevance of a certain ESG aspect to the total evaluation.

Therefore, it is essential, both for investors and for the companies analyzed, to know the methodologies of the different providers of ESG ratings and indices and not to make decisions based on a single source of information. In this way, the existing divergence will not pose a barrier to the management of their investments and to transparency vis-à-vis their external stakeholders.

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Is there skepticism among large asset managers?

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The analysis of different ESG rating agencies can lead to very useful conclusions as part of a responsible investment strategy. However, the divergence between the main evaluators also causes a loss of credibility for certain asset managers.

Recently, the head of risk monitoring at Norges Bank, the world's largest sovereign wealth fund, stated in a Interview with Bloomberg that their analyses incorporated ESG ratings “very rarely”, if at all. Instead, the Norwegian fund has developed a sustainable investment methodology, disaggregating the information provided by the ESG ratings and then treating it based on its own criteria.

This perspective, which is increasingly widespread among asset managers, is followed in Spain by entities such as Santander AM or BBVA AM, which have their own tools to evaluate the information provided by external suppliers and incorporate it into their investments.

Therefore, the potential skepticism that exists among investors appears as another consequence of the controversies derived from the lack of standardization.

It is not so much that the divergences between the ESG score awarded by different rating agencies make their analyses lose relevance, but rather that they bring to the table the need to know the details of the different methodologies used in order to make the most of the information analyzed.

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The path to standardization and other future opportunities

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With a landscape as complex as the current one, they appear two main tools for consolidating ESG ratings as a basis for responsible investment: the advancement of regulation and support for ongoing initiatives around the standardization of ESG assessments.

First of all, the regulation regarding the reporting of non-financial information and classification of investment products will serve to reduce controversies associated with ESG ratings. In that regard, at European level there are many hopes placed on the consolidation of environmental and social taxonomies and the Regulation on the Disclosure of Sustainable Finance of the European Union (SFDR), as a framework on which to evaluate the non-financial impact of investments.

On the other hand, with regard to ESG ratings directly, the most relevant initiative currently is the definition of sustainability reporting standards at the international level, which is being carried out by the International Sustainability Standards Board (International Sustainability Standards Board or ISSB, for its acronym in English).

Created within the framework of COP 26 and led by the former CEO of Danone Emmanuel Faber, the ISSB reports directly to the International Financial Reporting Standards Foundation (IFRS).

Responding to the demands of the different stakeholders in the sector, it is expected that the setting of ISSB standards will serve to end once and for all the lack of transparency and bring clarity to ESG investment.

In addition, the Foundation currently consolidates two of the sustainability reporting standards with the highest international adoption, the Sustainability Accounting Standards Board (SASB) and the Carbon Disclosure Standards Board (CDSB), and signed a collaboration agreement in mid-March 2022 with the Global Reporting Initiative (GRI). Therefore, the ISSB combines the financial perspective of the risks associated with ESG aspects with the vision regarding the impact that companies generate on the environment and society.

Thus, it is expected that the current complex landscape of ESG ratings and indices, which currently requires an in-depth analysis of methodologies and suppliers, will begin to take steps towards homogenization in the medium term. In this way, companies and asset managers will be able to focus their efforts and strategies on what is really important: building a just and responsible society for all.