Introduction

This post highlights some features regarding ESG ratings that investors may not be fully aware of

1.) Not all ESG ratings are about firms’ impact on the planet or society

In fact, the largest purveyor of ESG ratings, MSCI, measures firms’ sensitivfity to ESG factors, such as climate change, rather than firms’ contribution towards such factors.

Firms’ ESG scores fall into one of two categories:

  1. scores which measure firms’ impact on the planet and society
  2. scores which measure firms’ sensitivity to ESG factors, such as climate change

One of the most prominent providers of ESG scores, MSCI, fall into the latter category. It should be pointed out that MSCI are very open about the fact that they assess firms’ exposures to ESG factors. However, most investors in ESG funds believe they are investing in 1. rather than 2., according to MSCI’s CEO in an interview during COP26:

No, they for sure don’t understand that, I would even say many portfolio managers don’t totally grasp that. Remember, they get paid. They’re fiduciaries, you know. They’re not as concerned about the risk to the world.

One of the fiducaries who has benefitted the most from fund flows into ESG investing is BlacRock. MSCI ratings are a vital input into it’s ESG funds but a 2021 Bloomberg Intelligence analysis showed that BlackRock’s iShares ESG Aware MSCI USA ETF (the largest sustainable investment fund in the world) held a portfolio that closely tracks both the S&P 500 and BlackRock’s own top-selling S&P 500 fund, with two notable exceptions: The ESG fund had a “sustainable” label thanks to MSCI, and was more heavily weighted in 12 fossil fuel stocks than the actual S&P 500.

High ESG ratings ≠ Positive Environmental and Social Outcomes

Several studies have shown that ESG scores are not associated with positive environmental and societal outcomes. For example, Raghudan and Rajgopal (2022) find that companies with high Sustainalytics ratings in ESG portfolios have worse records for compliance with labour and environmental laws relative to companies in non-ESG portfolios over the same period. Companies added to ESG portfolios also do not subsequently improve compliance with labor or environmental regulations. Conversely, Gibson, Glossner, Krueger, Matos, and Steffen (2022) find that U.S. firms that join the Principles for Responsible Investment (PRI), which commit a company to incorporate ESG factors into their decision-making processes, earn worse ESG ratings (as assigned by MSCI, Refinitiv, and Sustainalytics) than U.S. firms that do not make this commitment.

Disagreement between ESG ratings providers

In early 2022, S&P dropped Tesla from its S&P 500 ESG Index because of perceived deficiencies in many different ESG areas, such as:

  • Tesla’s lack of an internal low carbon strategy for reporting and reducing carbon emission

  • insufficient codes of business conduct

  • claims of racial discrimination and poor working conditions at a California factory

  • poor handling of a federal investigation into deaths and injuries linked to Tesla’s autopilot vehicles

This prompted Elon Musk to tweet that “ESG is an outrageous scam! Shame on @SPGlobal”. Tesla was not dropped from other comparable ESG indices.

The differing treatment recieved from Tesla serves to highlight the difference between ESG ratings providers. Providers use a variety of different measures which are aggregated and weightedly differently from one provider to the next. Some providers rank ESG scores on a relative industry basis and some on a global basis.

Pairwise correlations across some prominent ESG ratings providers, for S&P 500 companies from 2007-2017:

Sustainalytics Inrate Bloomberg FTSE KLD MSCI
Asset4 0.75 0.23 0.75 0.57 0.52 0.40
Sustainalytics 0.30 0.69 0.61 0.56 0.43
Inrate 0.12 0.27 0.29 0.32
Bloomberg 0.59 0.48 0.30
FTSE 0.49 0.27
KLD 0.44

source:

Sustainalytics Inrate Bloomberg FTSE KLD MSCI
Asset4 0.331 0.297 0.432 0.027 0.104 0.132
Sustainalytics 0.401 0.327 0.160 0.089 0.135
Inrate 0.344 -0.029 0.081 0.145
Bloomberg -0.027 0.153 0.060
FTSE -0.065 0.023
KLD 0.133