Standardizing Criteria Key Challenge for Booming ESG Market

Art by Dadu Shin

Investor interest in environmental, social, and governance (ESG) frameworks is booming. Institutional allocations quadrupled over the last decade, and 40% of asset managers use the criteria to make investment decisions. But investors must now navigate a key challenge as they clamor to embrace ESG: a lack of standardization can lead to conflicting and contradictory ratings on where an investment stands ESG-wise.

Say you’re an ESG-minded investor eyeing Bank of America stock. To help you assess whether to buy, you turn to ESG ratings services. Trouble is, they’re all over the place and too often contradictory.

Sustainalytics, one of the most prominent ratings firms, gave BofA a 70 score, well above average, according to a recent study from the  American Council for Capital Formation (ACCF), a think tank. But a competitor, RepRisk, gave the bank a CCC, which by that rater’s gauge was below average, ACCF said.

What gives? The bank has slogged through a terrible mess stemming from the financial crisis, due to its huge exposure to bad mortgages. Yet to one ratings outfit, it is a winner, and to another, a sinner. Neither the raters nor the lender responded to requests for comment.

“The heart of the problem is that there is a lack of standardization,” said Ian Simm, CEO of ESG-oriented Impax Asset Management. Raters all scrape data from company filings, But beyond that, they go in all sorts of directions searching for pertinent information—like sending the companies questionnaires, reading media articles about them, and talking to advocacy groups. Just compare the disparate ESG grades to those for corporate finances. Financial ratings are 100% based on uniform criteria, mainly regulatory filings, and seldom differ wildly, whether from Standard & Poor’s, Moody’s Investors Service, or Fitch Ratings.

Asset managers, as well as individual investors, are increasingly incorporating ESG assessments into their decision-making about stocks and other corporate securities. The Callan Institute annual ESG survey found that 40% of asset managers now use ESG factors in investing, up from 22% in 2013. 

Reducing risk—not just boosting returns or being socially mindful —are key reasons for the embrace.

The key question amid the booming interest: How helpful are the ESG ratings?

Indeed, it’s tougher to assess ESG criteria, which usually are more subjective than balance sheets and P&L statements that operate under long-settled accounting rules. The most established segment of ESG is governance. For decades, regulators have scrutinized board and management operations. Witness the current SEC inquiry into Tesla CEO Elon Musk’s controversial tweet about going private.

The E and the S parts—measuring, say, how much a chemical plant affects the atmosphere or how hostile a workplace is for women—“are woolier, and the result of a free-for-all” in the ratings, Simm said.

As a result, Goodyear Tire & Rubber got a 68 rating from Sustainalytics, which is 15 points above its industry average. “However,” the ACCF think tank declared, the tire maker has been hit with “asbestos-related claims, various OSHA fines, and litigation settlements.” Goodyear responded by pointing to its annual “corporate responsibility report,” which touts its efforts on matters including workplace diversity, land use, and ethics training.

Getting a good ESG score appears to be partly a function of size. ACCF, in its study, noted that larger companies tend to have better ESG scores than smaller ones. That’s perhaps because the small-fry lack the resources to churn out voluminous, if perhaps self-serving, disclosures on their do-good practices.

Pharma giant Bristol-Myers Squibb (market cap: $100 billion) fared well from Sustainalytics with a 77 score, which was 20 points better than the healthcare industry average, the ACCF found. Meanwhile, another less hefty player in the same sector, Phibro Animal Health ($2 billion), received a mere 46.

And the drug giant’s superior score, the study said, came despite a $14 million Securities and Exchange Commission fine of Bristol-Myers in 2015 for allegedly bribing Chinese hospitals to boost prescription sales. The company neither confirmed not denied the charges then, and refused comment to CIO.

European companies tend to do better than those in the US in the ratings, ACCF noted, concluding that stricter European Union mandates make their corporations more diligent about ESG disclosure. So Sustainalytics gave BMW a sterling 93 score, even though it is mixed up in the scandal over rigging emissions tests. The auto company didn’t return a request for comment.

That said, how ESG ratings are formulated is somewhat of a mystery. The Wall Street Journal wrote that Berkshire Hathaway, home of one of the patron saints of honest investing, Warren Buffett, got mediocre to poor grades on this front. Berkshire reportedly received the lowest ESG score of any S&P 500 member from FTSE Russell, while MSCI ranked it at the lower end of its average category.

Pollution, sexual harassment, or any other bad deeds don’t seem to be associated with Buffett’s conglomerate. MSCI told the Journal they don’t disclose rankings, and didn’t immediately return CIO’s request for comment. FTSE Russell refused comment.

To be sure, MSCI and many other raters do issue general explanations of what factors go into their ratings. MSCI, for instance, says on its website that it combs through government and nongovernmental organization databases, as well as company disclosures, to arrive at its judgments. Then it scores a company on key issues important to its industry using a “rules-based methodology.” But no more details are divulged.

Actually, common ESG standards do exist, although raters still go their own ways. These yardsticks are issued by a body called the Sustainability Accounting Standards Board (SASB), which makes no ratings itself, but encourages the raters to integrate the SASB standards. For example, for electrical power-generating companies, SASB advocates looking at how much ash is left after burning coal, and how much of it is recycled.

SASB is something like the Financial Accounting Standards Board (FASB), which establishes accounting rules for US companies. The difference is that FASB’s edicts have the force of law, while the sustainability body’s precepts are more like guidelines.

Ratings agencies all over the world use SASB as a basis for their grades, and the disparity results from the raters adding their own data. Often this means judging companies’ policies and goals, an area SASB does not cover. The raters inquire, for instance, if a company has a health and safety policy, and an energy use reduction target, said Nicolai Lundy, director of education and partnerships for the SASB Foundation. “Little quantitative data is involved,” he said.

What’s also difficult to tell is how raters weight various items. James Hawley, head of applied research for True Value Labs, which rates ESG, wrote that some raters mix in economic factors with ESG ones, while others focus on “their versions of what is ‘ethical,’ and may minimize” environmental concerns.

One possible plus for companies with so-so market performance yet good ESG scores: ESG-oriented investors will be more forgiving of laggard stocks. “Investors in ESG products tend to be more patient and care less about performance than investors in traditionally managed products,” Todd Rosenbluth, director of fund research at CFRA, told Reuters.

Unless common standards are adopted universally, how can investors cope with a Tower of Babel-like panoply of ratings approaches? A number of large institutions don’t depend on one rater, said Hugh Lawson, chief of ESG investing for Goldman Sachs Asset Management. “A single rating is not useful, and is simplistic,” he said. “We use a wide range of them and then do our own analysis.” 

For those willing and able to perform that examination, some semblance of ESG reality can emerge to aid investing decisions. But this isn’t easy. A 2017 McKinsey research paper concluded that even large, sophisticated investors employ ESG “techniques that are less rigorous and systematic than those they use for other investment factors.”