The Deepwater Horizon oil rig disaster in 2010, which killed 11 workers and released almost 5mn barrels of oil into the Gulf of Mexico, was not just an environmental cataclysm. It also changed the financial industry.
Until then, sustainability ratings had been a niche business. For companies that made their living providing data and creating indices for financial markets, evaluating the environmental, social and governance performance of companies seemed like, at best, an interesting sideline.
The Gulf of Mexico spill brought ESG risks to the world’s attention and made investors more wary of companies that exposed them to further fall-out.
The sector has since been transformed. ESG ratings now influence, and in some cases dictate, which stocks and bonds make it into the $2.8tn of investment funds that are, according to Morningstar, marketed as sustainable. Its products lend legitimacy to the companies and investors who claim to be helping hit the Paris Agreement goal of limiting global warming to well below 2C above pre-industrial levels.
Yet that power is now coming under intense formal scrutiny. For the first time, regulators and politicians in Europe, Asia and the US are determined to bring more transparency to how the ratings are derived and ask questions about whose interests they really serve.
European lawmakers will later this year debate a proposed law that would force ESG rating agencies to break from their consultancy arms, disclose more details about their methodologies and formally register with authorities. In India, the securities regulator has insisted that agencies publish their methodologies.
In the US, where there has been a political backlash against some aspects of ESG, Republican politicians have accused data providers of arming investors with analysis that could prompt them to ditch red-state oil and gas companies. A Republican member of the US Senate banking committee asked a dozen companies last year to share information on how they come up with ratings.
ESG ratings look and sound like the familiar credit ratings produced by S&P, Fitch or Moody’s. In reality, there are two crucial differences: analysts are not yet subject to regulatory scrutiny on conflicts of interest, and they work in part on unaudited environmental, social and governance data, rather than in audited financial statements.
The European Commission said in June that potential conflicts of interest plague ESG data giants in three areas: the sale of ratings, data and indices to the same investor clients; the sale of consultancy services to help companies improve their ratings; and the practice of charging companies to display their own rating on financial products.
Daniel Cash, a credit ratings specialist and ESG ratings lead at the Hong Kong law firm Ben McQuhae, compares this situation to how credit rating agencies operated before the 2008 financial crisis, which drew the attention of regulators to the potential for ratings to be skewed towards paying clients.
“They were using consultancy services as cash cows and essentially the rating agencies are doing the same thing,” he says.
The ratings agencies insist they have taken a number of steps to professionalise over the last decade, including erecting informal “Chinese walls” to separate analysts from client-facing teams, and to counter concerns that scores can be improperly influenced. They also point out that it is investors who usually pay for ESG ratings, bypassing one of the issues that has been a source of criticism of credit ratings, which are often paid for by the companies themselves.
There is a further potential problem for the industry — the gap between the perception of what ESG ratings assess and what they actually demonstrate. The scores are not designed to measure corporate performance on carbon emissions or pollution. Instead, the raters measure how well a company is managing environmental, social and governance risks to their own bottom line, for example from hurricanes or carbon taxes.
“There is disillusion and confusion when people realise the labels mean very little or do not measure what they want them to measure,” says Fabiola Schneider, an assistant finance professor at Dublin City University and co-lead of the GreenWatch project to spot exaggerated claims in sustainable finance. “And you have investors trying to exploit that confusion and attract capital by appearing greener than everyone else.”
Attempts by regulators in recent years to create formal definitions of a “sustainable”, “transition”, “green” or “low-carbon” investment have challenged the way these ratings have been used by financial institutions over the past decade. This has fuelled demand for data that can justify the use of these terms and highlighted deficiencies in the ESG rating system.
“The finance industry has seen the opportunity [from the rise of the ESG data industry] to sell a lot of people a lot of new products,” says Lindsey Stewart, head of investment stewardship research at analytics company Morningstar, itself one of the biggest providers of ESG data through its subsidiary Sustainalytics. “Now people are expecting all those sustainable products to do something and it’s not obvious to everybody that they do.”
A concentrated market
Scrutiny from regulators is hitting the ratings providers after a decade of mergers and acquisitions that have created a handful of dominant players — and which have sometimes blurred the distinction between companies that offer ESG ratings, and those that provide market indices or traditional credit ratings.
The biggest company in the sector is MSCI, a provider of global market indices. It has retained its position in ESG ratings by diversifying earlier and faster than its rivals, including by spending $913mn on Burgiss, a New Jersey-based specialist in data about private assets, in an acquisition completed in August.
The other large players include the London Stock Exchange Group, proxy adviser ISS, Morningstar and credit rating agencies S&P Global and Moody’s.
In addition to growing market concentration, the handful of companies that dominate ESG data and ratings also sell most of the lucrative indices on which many sustainable funds are built.
According to a paper published by Jan Fichtner, an economist at Germany’s Bundesbank, and co-authors at the Danish Institute for International Studies in May, MSCI had around five times the market share of the second-largest index provider for sustainable funds — S&P Dow Jones Indices.
Indices built by MSCI were used in 56 per cent of large sustainable funds, rising to 68 per cent for passive funds that track an index. MSCI describes its indices work as “functionally separate” from its ratings business, which is managed separately “with editorial independence”.
This level of influence over interconnected markets has given a handful of rating agencies the ability to define what an ideal “green” stock, bond, fund or investing strategy looks like, says Fichtner.
“Only two or three ESG providers in the end matter,” he says. “They will de facto determine what ESG is and all investors will follow.”
Potential conflicts of interest stem from ESG data giants’ reliance on data produced by the companies they rate, and the potential for either investors or companies to influence the score.
Some in the industry suggest, for example, that companies can influence ratings by spending more on consultants and other services that can help boost scores.
Publicly traded companies surveyed by the sustainability consultancy ERM last year said they spent between $220,000 and $480,000 a year to pay rating agencies to obtain their ESG score, or on consultancy services and other digital tools to improve their score. Investors it surveyed spent between $175,000 and $360,000 for rating, data and benchmarks.
Will Ballard, head of equities at Border to Coast, which manages UK government pension schemes, raises concerns about data sent to him and other clients by MSCI. Larger companies and those who interacted “frequently”, more than 10 times, with MSCI, were both more likely to have a high ESG rating, the research showed.
“The size of the skew in the data is such that you would be forgiven for leaping to conclusions and suggesting that the key determinant for a high ESG rating is simply your market cap,” he says. This points not to deliberate wrongdoing by MSCI, he adds, but the “scale of the [data disclosure] demands placed on companies”.
MSCI said its ratings methodology was “transparent and publicly available”. A person close to MSCI said that there was “no potential for a pay-to-play conflict” because investors, not companies, pay for its ratings. Companies that engage with its research team may have higher ratings simply because they care about and are focused on ESG issues.
Others in the industry worry about pressure on the agencies from companies and from the investors who pay for the ratings and who do not like to see big changes or downgrades. This dynamic, they say, has partly shaped the way that ESG ratings are designed.
Matt Moscardi, a former executive director at MSCI, remembers being summoned to the offices of Goldman Sachs when he was head of ratings for financial institutions to face criticism about the score the US investment bank had received. “They had a roomful of people and I was effectively on my own.”
“They yelled, they screamed, they threatened legal action . . . All the banks would do it,” says Moscardi.
Goldman Sachs said “we do not recognise this alleged behaviour as what we would expect of our people at any time.”
More than a decade on, an analyst in MSCI’s Mumbai office, who recently left the company and asked for his name to be withheld, says he and colleagues took calls from dozens of investors every month who were unhappy with a change in the rating given to a company in their portfolio.
There was also a “fair share of arguments with companies”, who “didn’t care for the ratings”. While these complaints by companies being rated were mostly fielded through other teams, analysts were aware of them.
Proposing a major downgrade or upgrade to a company’s ESG score meant being hauled in front of a committee of superiors, who took the final decision, the analyst says. “If there is a big swing that’s not something that ideally is acceptable. It needs to be justified. It might bring up a question with the methodology,” the analyst adds.
A spokesperson for MSCI said its ESG research division “maintains a strong culture of independence and transparency in providing ESG ratings to global investors”. Its ratings are produced using “transparent and publicly available” methodology.
To counter the possibility of analysts coming under emotional or legal pressure from companies they rate, the biggest providers have increasingly tried to prevent them from speaking directly to the companies. Basing scores on algorithmic analysis of controversies and risk, and on publicly available information, can minimise the chance of bias creeping in, according to executives in the industry.
Steven Bullock, global head of research methodology at S&P Global’s data division, Sustainable1, says the organisation uses a “four eyes” approach for its ESG score, which must be checked by two analysts, before a further “assurance check” by their superiors before any big swing in ratings is approved.
Ambiguity or distortions in how ratings are built matter because ratings are increasingly used by unseasoned retail investors, not just the asset management behemoths who operate their own sophisticated credit and sustainability risk models. Since 2022, EU rules have required financial advisers and intermediaries in the EU to ask retail investors about their sustainability preferences and to offer suitable products.
Eric Pederson, head of responsible investments at Copenhagen-based Nordea Asset Management, has recently raised a number of concerns with the dozen rating providers he buys data from. These include marking one company down for too long because of a historic controversy in Turkey, failing to flag weapons sales to Myanmar by another, or overemphasising a wind turbine company’s reliance on carbon-intensive steel rather than its long-term potential to cut global emissions.
An increasingly popular product sold by the top agencies, so-called “temperature ratings”, measure what warming trajectory for the planet the company’s actions align with. These can be “totally misleading”, Pederson says.
The small print for most ESG ratings explains that stocks and bonds are rated on their ability to manage risks relative to peers in the industry — not on how they affect the planet. Each provider uses proprietary “weightings” to determine how much importance risks have, varying minutely for subsections of each industry.
At MSCI, the carbon intensity of operations makes up a fifth of the final score for a company that refines oil and gas, but just 12 per cent for one that sells coal. The company says its ratings are “not designed to measure a company’s impact on climate change”.
Shai Hill, chief executive of Integrum ESG, a challenger to the bigger ratings agencies, says high rating scores are “reassuring if you’re a pension fund trustee and not very experienced. You look at it like you look at someone’s school grade.”
Pederson says clients have sold out of his funds overnight because of changes to the rating a basket of stocks gets from a major provider.
“Intuitively you think it tells you something about whether the company is behaving in a way that is commensurate with climate change, or good or bad for the environment,” says Pederson. “The rating providers historically have not done enough to disabuse the public of that impression.”
Given the different pressures they face from regulators, with growing sceptcism in the US about net zero, some companies might be forced to choose which side of the Atlantic they wish to prioritise.
Morningstar, which owns the number two in the industry, Sustainalytics, is moving towards being “less front-foot on social issues”, according to a person familiar with the change, in a deliberate pivot largely driven by the US political climate.
Some executives fear this could risk upsetting European clients, increasingly required by regulators to focus on risks to society and the planet, rather than to business, the person says.
Simon MacMahon, head of ESG research at Sustainalytics, says the growing scrutiny and “increasing politicisation of ESG in some markets . . . has not changed our focus or our commitment to including any type of ESG issue, including social issues, in our analysis of companies.”
MSCI also insists that it is not changing its focus.
A flurry of reporting requirements being introduced by the EU and the US will widen the pool of available data on everything from pesticide use to carbon emissions, adding complexity to the task of rating agencies.
This will also make it harder for regulators, who are more accustomed to monitoring credit rating agencies. “The credit industry generates just one signal,” says Bob Mann, chief operating officer of Sustainalytics up to June. “Within the ESG industry you have a never-ending development of new signals.”
The more data points rating agencies have to assess, the more they could be tempted to use proprietary algorithms and machine learning tools to do the crunching.
“The economics of the industry will push towards machine use,” Mann adds. This in turn could make it more difficult for regulators and retail investors to make sense of already opaque methodologies.
Fearing that ESG is becoming an easy target for attacks, amid the growing political disputes over net zero policies in the US and elsewhere, executives say some providers are setting up a trade association for the first time.
By positioning themselves as neutral conduits for information, with no influence over the actual investment decisions around the net zero transition, some in the industry hope to avoid getting tangled up in the climate culture wars.
Data providers will increasingly argue in public that “this product does nothing to change the world,” says Stewart at Morningstar. “It is more an expression of your own values and preferences.”
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