Writer: G. Krisna W. PANDE
Social Media Team: George K. KIONGSON
Source: Photo by Pixabay on Pexels
ESG ratings in a nutshell.
ESG, which stands for Environmental, Social, and Governance, refers to the three central factors used to measure an investment's sustainability and ethical impact on a company or business. Environmental criteria assess how a company performs considering its environmental impact. Social criteria evaluate how a company manages relationships with its employees, suppliers, customers, and communities. Governance criteria examine the quality and transparency of a company's leadership, board structure, executive compensation, and shareholder rights. Together, ESG criteria provide investors with a framework to evaluate companies based on their commitment to responsible and sustainable business practices.
Institutional investors are the ones who rely most on ESG data to make sustainable finance decisions. To paint a picture, institutional investors represent 80% of the New York Stock Exchange trade volume. Therefore, the reliability and efficiency of ESG data must be at best to ensure efficient allocation for socially responsible investment. Many ESG data providers and climate transition metrics have become available for use to institutional investors since the last decade, including Bloomberg, MSCI, and Refinitiv are among the most used.
Figure 1. Refinitiv ESG Rating Hierarchy
(Source: Refinitiv ESG Rating Methodology, LSEG)
Figure 2. MSCI ESG Rating Hierarchy
(Source: MSCI ESG Rating Methodology, MSCI)
Challenges across ESG ratings
In the three pillars, ESG rating providers assess and compute each company’s scores through a range of categories and sub-categories of sustainability-related metrics. There are commonalities in the factors used to assess, such as greenhouse emissions and emission intensity, however, ESG ratings could vary across rating providers (OECD, 2022). This score divergence causes inefficiencies and inconvenience to arise for investment managers. It causes difficulties in assessing ESG performance across companies. Also, it decreases companies’ incentives to improve ESG performance due to complex differences in different ESG raters’ methodologies.
Quoting from Berg, Kölbel, and Rigobon (2022), generally, three drivers drive the differences across ESG ratings, namely “Scope” divergence, “Measurement” divergence, and “Weight” divergence. “Scope” divergence, as the name implies, refers to the situation where ratings are based on different sets of attributes. This type of divergence emerges at a more macro level, implying that there is a difference in the attributes or sub-segments to assess a pillar. The “Measurement” divergence occurs when two agencies have the same attributes as a pillar, however, there’s a significant difference in how the attributes are measured, meaning different indicators. The “weight” divergence emerges when rating agencies apply different weights to the same attributes or indicators. Measuring divergence accounts for the largest driver for ESG rating divergence, contributing up to 56% of divergence.
Current State of Sustainable Finance in the European Union (EU)
In February 2024, the European Union reached an agreement on a proposal that environmental, social, and governance (ESG) rating agencies should be supervised by a governing body. Under this new regulation, ESG rating providers would need to be authorized and supervised by the European Securities and Markets Authority (ESMA) and comply with transparency requirements regarding each one’s methodology and source of information. This regulation will ultimately ensure transparency and reliability of ESG ratings across rating agencies and improve investors’ confidence in the capital markets to strengthen sustainable investing practices. Based on the latest news, here are the key points mentioned by the newly proposed regulation:
- Under the new rule, all unregulated ESG raters in the EU area will need to be supervised by the European Securities and Markets Authority (ESMA). The ESMA itself was founded in 2011 to replace the Committee of European Securities Regulators, being a centralized agency that improves investor protection and promotes stable financial markets within the EU.
- ESG ratings from agencies outside the EU will need to have their ratings endorsed by raters regulated in the EU.
- ESG raters regulated by this law will have to separate their ratings for each of the three pillars. However, if only a combined ESG rating is supplied, they will need to make the weighting of each E, S, and G pillar explicit.
- Rating on the environment pillar would need to state that it took into account alignment with the Paris Agreement on reducing carbon emissions.
- The regulation will also consider the development of smaller ESG rating firms, allowing them to comply with a lighter and less strict version of the rules to help them compete with large players such as MSCI, Moody’s, and Sustainalytics.
- The regulation would most likely come into force sometime around 2025.
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Citation
OECD (2022), ESG ratings and climate transition: An assessment of the alignment of E pillar scores and metrics, OECD Business and Finance Policy Papers, OECD Publishing, Paris, https://doi.org/10.1787/2fa21143-en.
Berg, F., Koelbel, J. F., & Rigobon, R. (2022). Aggregate confusion: The divergence of ESG ratings. Review of Finance, 26(6), 1315-1344.