Consistent ESG ratings a must as demand for related investments grows

OVER the past couple of years, sustainable investments - specifically the use of ESG metrics (environment, social, governance) to analyse and screen securities - have gathered force.

Based on research by the Global Sustainable Investment Alliance (GSIA), assets invested by ESG integration have grown by nearly 70 per cent between 2016 and 2018, from US$10 trillion to US$17.5 trillion in assets. ESG integration is defined by GSIA as the systematic and explicit inclusion of ESG factors into financial analysis. The US is the biggest investment market by far to use ESG integration, accounting for some US$11.6 trillion in assets. Some three quarters of the assets are managed on behalf of institutions, and the balance for individuals.

Not surprisingly, as more investors and institutions embrace ESG in financial analyses, a thriving ratings industry has sprung up, focusing on generating ESG research and scores. As their services flourished over the past decade, a wave of consolidation and mergers has also set in. For instance, in 2010, MSCI acquired RiskMetrics Group, which itself had previously acquired a number of firms, some specialising in ESG research. Morningstar took up a stake in Sustainalytics, a leading provider of ESG research and ratings in 2017. More recently, Moody's acquired a majority stake in Paris-based ESG ratings provider Vigeo Eiris.

Yet, even as ESG integration gathers steam, there is little standardisation in terms of ESG scoring and reporting, a paper by State Street Global Advisors (SSGA) points out. Over an 18-month period, SSGA looked into more than 30 data providers for consistency of scores. Between the two largest data providers MSCI and Sustainalytics, using constituents of the MSCI World Index as a base, it found a correlation of only 0.53, which means the ratings are consistent for only half of the universe covered. There is also a lack of transparency on the methodologies.

Separately, a paper by the Flossbach von Storch Research Institute, a German think tank, points out that ESG ratings agencies do not offer complete information about the criteria and assessment process, which makes comparisons difficult. What's more, there may be trade-offs among the criteria - that is, a high score in one aspect may be offset by a low score in another. A case in point is the inconsistency in the ratings in the automotive industry. Volkswagen AG, for instance, scored zero for MSCI ESG, and 19 points for Sustainalytics. RobecoSAM awarded the firm 65 points.

Thankfully, efforts to set standards are growing. Last year, the US-based Sustainability Accounting Standards Board (SASB) published the world's first industry-specific standards, outlining the sustainability factors most likely to have financially material impact on 77 industries. Adhering to the standards will inject consistency into company disclosures. It should also complement the efforts of other bodies such as the Task Force on Climate-Related Financial Disclosures, which focuses on more effective climate disclosures. For SASB, industry leaders such as GM, Merck and Kellogg's have begun to use the standards. SASB is also supported by large asset managers including BlackRock and Franklin Templeton.

To be sure, the road to ESG comparability will take some time. The silver lining is that as more asset managers and investors demand and adopt ESG integration, the goal of standardisation should become a reality sooner rather than later.