The Rise of the Single Company ESG Rating
The Good. The Bad. And Where We (Might) Go From Here
There is no longer any doubt that ESG investing is a major force with estimates now exceeding $20 trillion. The days of negative screening, excluding “sin stocks” or oil and gas companies, are long past. ESG Integration is now a major focus of Wall Street and with it real progress and some warranted skepticism.
“The Remarkable Rise of ESG” a short piece by George Kell, Forbes, July 11, 2018, does an excellent job of walking through the early days of SRI and how far we have come. More recently “How Socially Responsible Investing Lost It’s Soul” by Rachel Evans, Bloomberg BusinessWeek, December 18, 2018, suggests a wake up call, warning that Wall Street is now, as is predictable, churning out ESG product that will disappoint the likely naïve but well intentioned. Taking just one aspect of where we are today, the single company ESG rating, this can be used to check our current position on the evolution of ESG investing and help us to project where we are likely headed from here.
As an active participant in risk and quantitative investment analytics the rise of ESG and SRI factors, research and investing has thus far been a captivating journey. With the single company rating it is hard not to be drawn into reflecting back on the headline use of VaR (value at risk) as “the best single measure of risk” (before 2008 that is). While practitioners knew a single risk measure was not a full answer to any question there was not a lot of effort made to broadly educate and communicate on the known limitations. Vendors pushed their system’s ability to produce a VaR measure, increasing emphasis on a single number as a panacea for a very complex reality. To be fair, with ESG ratings we are not looking at a huge underestimation of potential losses but I think there are some helpful parallels.
There has been a lot written on “the inconsistency” of ESG ratings and how the approach taken by vendor supplied ESG analysis can vary and just how wide the results can be between ratings agencies. CRSHub did a study in 2018 where correlation between company level ESG ratings between two leading vendors was only 0.32 (pretty low vs. 0.90 in their example for Credit Ratings). These statistics will not surprise practitioners but as in the VaR example this did surprise the majority of investors who had less knowledge/exposure (prior to 2008/9).
Keeping it simple let’s start with positives and potential negatives about a single ESG rating.
A single score drives more widespread access to ESG analysis, investment decisions for many (retail investors/ wealth management), and revenue growth for most direct participants. The rising use of the single company ESG score and its use in portfolio or index scores and index creation is telling. The two largest ESG ratings agencies, MSCI ESG and Sustainalytics are leading and benefiting. In summary what’s driving the focus on single company ratings comes down to first, “follow the money” but also the fact that – it is the practical first choice today for over 80% of users.
- Allows more investments and investment decisions to be powered, or partially powered by ESG ratings. Supports creating and marketing products that can be successful with broad audiences.
- A top-level score is a great first step in a screening process, to bring in names or weed some out. Similarly for monitoring changes. This provides a much improved and sophisticated approach rather than for example screening out by industry (Oil and Gas, Tobacco as an examples).
- People want easy answers, not lots of data and questions. Looking at individual factors ratings within say the Governance category might just lead to confusion. People struggle when sifting through too much data. So even if a company level ESG rating may be inconsistent with that from another “credible source”, or important underlying factors might be showing specific high risk, the need for an answer wins.
- Pick your poison – This allows for balance of where companies are doing well and avoids penalizing too much for maybe what hits headlines or could be present in specific underlying ratings or factors.
- It reduces even bigger inconsistencies potentially in the underlying discrete measures/ factors. The rolled up rating will reduce that noise. Smoothing out the bumps that may annoy or distract people is not a bad thing.
- Mutes out, at least to a degree, specific known unresolved biases. There are well-documented issues that show problems with ratings related to size, geography, and industry.
- It gets people using and paying for research/ ratings in general (because they will only use at this level). Creating more revenue for the ratings industry will increase the quality and consistency of the underlying analysis over time. More people looking at top line data drives usage down in the detail by the heavy analytical users.
Too much focus on the single rating could lead companies to solely manage to that number/rating. A single rating could hide important information. Instead of bringing more focus to critical issues, the merged score could potentially turn the spotlight off. If the top-level score ends up being all-important then that is where the focus will be, and taking pressure off specific issues that are impactful (within individual E, S & G topics/ areas).
- External pressure on companies to address specific shortcomings could actually be reduced. Emphasis on a single topline number/ rating could reduce pressure on companies who are rated low in specific areas – except in the most extreme cases. This gives them the ability to say – “But overall we are doing well, we have to look at the full picture, which we do and …”.
- Internal resource and financial commitments to address specific shortcomings could be reduced if just the overall rating is what gets attention. The details become less important. Manage to the top-line number.
- If all incentives are connected to a top-line rating then all actions will be as well. Incentive examples, inclusion in an index, a portfolio, how a company is compared to another for factor/ quantitative inclusion/selection or just an individual comparing two stocks…
- Investment Managers who had been conducting their own research have often found that their funds don’t score as well as they would expect when scored by ratings firms. AUM could flow away and direct research conducted in-house (away from ratings firms) could be reduced.
- Investment managers and ESG branded firms that rely on single external ratings could see the lion’s share of AUM growth.
- Further consolidation and reduction of firms doing ESG research. Specialized “best of breed” ratings firms that only focus on specific issues such as for carbon impacts (within E) would need to partner or be acquired to be a part of producing a single rating. With the importance and value of their research reduced, the overall quality/depth of ESG research available in the market may diminish.
- Reduces pressure on Ratings firms to increase the quality of their individual factor ratings. Single score can be disconnected, backward looking but more easily momentum building (self fulfilling outperformance).
- There has been criticism in the credit world of conflicts of interest between the issuer and rating agency. The focus on the single rating could increase the potential of this also leading to conflicts in ESG.
- Could increase breadth over depth of coverage, presenting a disincentive for providers to increase the depth of research (analysis within categories) and just focus on covering more names.
- Delays the replacement of overly subjective methodologies not maturing into more structured objective transparent approaches. With less scrutiny on the underlying methodology, the improvement of individual underlying factor scores will be slower.
We can expect that the single rating will persist. It’s easy, handy and approachable. It is no doubt a vast improvement over negative screening for example based solely on industry. If as investors and information consumers we are interested but do not want to have to get into the detail, for now this could be just right. Maybe we will see more conversation about the use of single scores for the E, the S, and the G. Some will argue that the Governance rating should always be on its own and that Social and Environmental have more standing as a combo.
Increasing interest in investment decisions and allocations to ESG Investments will allow for more options and choices, both around what analysis and ratings are produced and what investment opportunities are made available. The analytics and the investment opportunities don’t have to be totally in sync but it’s best when the mutual support is there and when the two have separation without conflicts. The rise of the single rating is strategically working for the largest ratings firms, with asset managers creating and marketing new products (ESG boutique firms), and with wealth management and the brokerage industry needing to keep it simple.
The fact that we are seeing criticism (the BusinessWeek article noted above as an example) is a plus. We can demand and expect continued evolution in how ESG ratings are produced and leveraged. The current scale and expected growth and inclusion of ESG factors and ratings in investment decision making will push through the current shortcomings that the overuse of the single ESG rating may present. The investment approaches and ESG products produced and sold today will doubtless be replaced by more sophisticated offerings that are backed up by higher quality data and longer histories as the ratings evolution continues.