ESG Ratings: Navigating Through the Haze

by Kevin Prall, CFA, CFA Institute.

How severe is the lack of correlation among ESG ratings?

A general consensus is forming in the business community: An enterprise focus on environmental, social, and governance (ESG) matters can yield benefits to a company. These may include higher valuation and better financial performance as well as increased access to capital and lower perceived operational and reputational risk.

While ESG may be the topic of the day every day, most companies struggle to understand the existing web of interconnected standards and disclosure requirements. The lack of an integrated reporting framework often results in disparate disclosures and inconsistent reporting. This can make it difficult to compare ESG efforts between firms and even within the same firm year over year.

In an attempt to synthesize this data for investors, ratings agencies have developed algorithms and scorecards to generate ESG scores and rankings. What remains to be seen is if these ESG ratings provide relevant insights on a company’s resiliency during the pandemic recovery.

To find out, we conducted an analysis of six separate ESG ratings providers for a cross section of over 400 companies across 24 industries. Our conclusion? Different ratings methodologies tell vastly different stories about the same company. This demonstrates the immaturity of the current ESG ratings environment and highlights the need for improvements.

Rating Agencies and Ratings Harmonization

For our analysis, we compiled ESG ratings from the following providers via Bloomberg data services:

  • MSCI ESG Research Rating assigns firms ESG scores ranging from best (AAA) to worst (CCC). These ratings are calculated by aggregating the weighted average of the key issue scores.
  • S&P Global ESG Rank yields a total sustainability percentile rating derived from the total sustainability score and based on the S&P Global ESG Rank.
  • Sustainalytics Industry Rank provides a percentile rating to companies based on their ESG total score relative to their industry peers. Aggregate ESG performance encompasses a firm’s level of preparedness, disclosure, and controversy involvement across all three ESG themes.
  • Carbon Disclosure Project (CDP) Score reflects a company’s degree of commitment to climate change mitigation, adaptation, and transparency. The only firms rated are those that respond on time to a questionnaire sent in response to an investor request.
  • Institutional Shareholder Services (ISS) Governance Score assesses a company’s governance practices.
  • Bloomberg ESG Disclosure Score is a proprietary rating derived from the extent of a company’s ESG disclosure.

Each ESG ratings provider has unique scoring conventions, so we had to develop a common system to harmonize them all. We developed a 10-point rating scale, with 10 representing the best ESG performance and 1 the worst. Each provider’s methodology and our conversion technique is as follows:

  • The MSCI ESG rating system ranges from best (AAA) to worst (CCC). AAA was assigned a 10, CCC a 1, and each of the seven intermediate integers were linearly assigned between 1 and 10 in increments of 1.43.
  • The S&P Global ESG Rank is a percentile score with 1 being the worst and 100 being the best. Each result was divided by 10.
  • The Sustainalytics Rank is a percentile rating with 1 being the worst and 100 being the best. We divided each result by 10.
  • CDP climate scores range from 0 (failure) to 8 (A). A was assigned a 10, 0 was assigned a 1, and each of the eight intermediate integers were linearly assigned between 1 and 10 in increments of 1.25.
  • ISS scores range from 1 (best) to 10 (worst). The inverse was used for each provided score, with 1 changed to 10 and 10 to 1.
  • Bloomberg ESG disclosure scores range from 0 (no information provided) to 100 (all possible information provided). Each result was divided by 10.

Conflicting ESG Ratings

While a strategic focus on — and investment in — ESG plays a critical role in an enterprise’s long-term financial resilience and performance, our analysis casts doubt on the ability of current ESG ratings to consistently convey this critical information to investors. An initial comparison of the six ESG ratings for each company in the study shows obvious disconnects among the ESG ratings themselves.

For example, MSCI, S&P, and Sustainalytics are all comprehensive ESG ratings. They should have a high correlation. But MSCI’s correlation with both S&P and Sustainalytics is below 50%. The S&P and Sustainalytics correlation is higher but still lower than expected. Though CDP, ISS, and Bloomberg all have different focus areas, they should still have greater alignment. All told, the results, presented below, are conflicting and contradictory.


ESG Ratings Comparison: Correlations

ESG Ratings Comparison

But just how severe is this lack of correlation?

For context, we looked at long-term debt ratings for the same 400 firms across the same 24 sectors. The Standard & Poor’s, Moody’s, and Fitch Ratings scores for these companies showed correlations between 94% and 96%.


ESG and Debt Ratings: The Correlations


One of the strongest correlations among ESG ratings was between Sustainalytics and S&P. That measured 65%, which falls short of the 96% correlation between Moody’s and S&P.

Conclusion

While ESG has become central to the capital allocation process for investors and corporations alike, the disparities between today’s ESG ratings limit their usefulness in extracting meaningful insights about a company’s financial resiliency and long-term value.

The path forward should focus on the fundamental analysis of ESG value drivers and reconciling rating methodologies.

This post was first published at the CFA Institute's Enterprising Investor blog.

Total
0
Shares
Previous Article

China's crackdown intensifies. What does it mean for emerging markets investors?

Next Article

Tech Talk for Tuesday August 10th 2021

Related Posts
Subscribe to AdvisorAnalyst.com notifications
Watch. Listen. Read. Raise your average.