Navigating the world of ESG ratings

Recent events such as the invasion of Ukraine and widespread divestment from Russian oil and coal have created an even bigger push for investors to move towards sustainable investing.

Data already suggests that ESG investing outperforms traditional investment strategies, and investors are increasingly using ESG rating agencies’ scores to help inform their investment decisions. A 2022 FundForum survey found that 88% of responding fund management professionals currently use ESG ratings, and 92% expect to increase their use.

The world of ESG ratings can be complex and frustrating to navigate. With so many varying opinions on the rights and wrongs of rating agencies, we have broken it down for you.

Do the rating agencies show us how ‘good’ at ESG a company is?

ESG ratings measure a company’s exposure to ESG risks and how well a company is managing those risks or, in other words, a company’s resilience to ESG-related risks. These risks are often overlooked in a traditional financial review, but can still haveimplications for  on a company’s bottom line. Critics say that the agencies do not accurately predict ESG risk, as it’s not as straightforward as predicting credit risk, which is what many of the models are based on.

Even if the agency does accurately predict ESG risk, this can lead to investors thinking a company is ‘good’ because it has a good rating, when in fact there may still be negative impacts from its operations. There are many instances of this.

For example, McDonald’s greenhouse gas emissions rose by roughly 7% over four years, but because MSCI had dropped carbon emissions from any consideration in McDonald’s rating, it actually got a rating upgrade due to environmental practices. MSCI determined that climate change neither poses a risk nor offers opportunities to McDonald’s’ bottom line, which goes against what we know about the beef industry’s impact on climate change, as well as other parts of McDonald’s supply chain. McDonald’s received a higher environmental score because it mitigated ‘risks associated with packaging material and waste’ relative to its peers, in locations where the company faces potential sanctions or regulations if it does not abide by waste laws. Here, it is clear that MSCI was looking at the potential negative impacts of ESG issues on the company, rather than also looking at the potential negative impacts of the company’s operations on ESG issues. The aim is to mitigate risks, and the benefit to the environment is secondary. There are two sides to this coin: although it may be less ethical to look at risks before impacts, there is a positive correlation between companies which properly manage ESG risks and having a more ethical approach to ESG.

Does one company receive the same rating from all rating agencies?

Unfortunately not. Rating agencies do not set out to score each company with the same grade, as having bespoke methodologies is their selling point. Rating agencies give an independent view of a company, which is a good thing, but this intentional divergence can cause confusion when there is a lack of scoring consistency between the agencies.

Are all companies rated by the rating agencies?

Due to the nature of rating processes and levels of corporate disclosure and regulations being vastly different in different geographies, there is an uneven distribution of raters’ attention on companies. This means that some companies receive very low scores, or none at all, which do not represent the reality of their operations. In general, lower standards of transparency and disclosure pose significant challenges to investors, but even more so when investors are relying on ESG scores from third-party rating agencies that look only at publicly available information.

So, should we ditch the ratings?

Although ESG ratings can be confusing, when used in the way they were intended they can help investors make better investment decisions. When used as a data point, rather than as a sole decision maker, the rating can be helpful to an investor as long as they understand what the score means. Ideally, investors should not rely on just one ESG rating but should use multiple ratings to influence their decisions. Additionally, combining the rating with other analysis such as sustainability reports, desktop research and direct engagement with the company will make for an optimal investment judgement.

Okay, understood. So, how can Luminous help?

Luminous can help you improve your sustainability disclosures so that rating agencies can more accurately score your company, which in turn can lead to better investment decisions by investors. If you would like to find out more, please get in touch: