Updated: Mar 25, 2022
What defines how sustainable a certain investment is? In today’s market, there are different ways of quantitatively measuring the impact of a certain derivative. These are commonly classified in a direct impact way, such as direct CO2 reductions or energy usage reductions, or through ESG scores. There are different types of scores that are being applied to financial instruments. Companies such as Sustainalytics and MSCI calculate ESG scores by measuring different variables. Rating companies, such as Moody’s, S&P and Morningstar assign a sustainability worthiness along their other ratings.
While these scores give an indication of the impact of the assets, the different agencies have different calculation methods, possibly leading to different sustainability ratings.
Sustainalytics’ ESG Risk Rating sorts companies into five risk categories: negligible, low, medium, high, severe (Sustainalytics, 2018, p.18). Through these five categories, the agency creates a single “currency” of ESG risk, independent of the analysed company’s industry. This allows for a global differentiating ESG score that gives a good idea of how sustainable the company is.
MSCI’s ESG rating takes “the weighted average of individual Key Issue Scores normalized relative to ESG Rating Industry peers.” (MSCI, 2020, p.4). The Key Issue Scores arise from in-depth analysis into the Environmental, Social and Governance risks the company is exposed to and rates them. These ratings are then weighted and aggregated into a single ESG score for across-the-market utilization. The difference with Sustainalytics is that there is a rating for each E, S and G risk.
In addition to rating agencies who solely focus on ESG ratings, credit rating agencies are also present on the market. Companies such as Moody’s and S&P provide an ESG score alongside credit scores. This allows investors to incorporate sustainability into their decisions, and most importantly, value in ESG premiums. S&P promotes its rating, for example, as “it provides a forward looking, long term opinion of readiness for disruptive ESG risks and opportunities.” (S&P, 2021)
Although ESG ratings are a practical measurement for the sustainability of a company, there are three central issues around current ESG ratings. The scores are based on self-reported data, rating agencies additionally utilise third party data, and the data is unaudited. In combination of unreliable information, how it is used is also agency-specific and can thus lead to different scores under identical circumstances.
Due to these different measuring methods, researchers at MIT Sloan found that the correlation between the 5 major ESG rating agencies was on average 0.61 (Berg et al., 2019, p.9). This correlation is rather low, considering that the correlation between the credit ratings from Moody’s and S&P is, for example, 0.99 (Nikolov, 2021)
To increase the reliability of these ratings, it is in the market’s interest to create standardized methodologies and assessments. This goes in line with the need for standardized definitions of sustainable derivatives and indicates that regulation is the path to a homogenous market.
Berg, F., Kölbel, J., & Rigobon, R. (2019, August). Aggregate Confusion: The Divergence of ESG Ratings (No. 5822–19). MIT Sloan School of Management. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3438533
MSCI. (2020, November). MSCI ESG Ratings Methodology. MSCI ESG Research. https://www.msci.com/documents/1296102/21901542/MSCI+ESG+Ratings+Methodology+-+Exec+Summary+Nov+2020.pdf
Nikolov, V. (2021, June 23). TenderAlpha :: Blog :: What Makes ESG Ratings Problematic. TenderAlpha. Retrieved 3 December 2021, from https://tenderalpha.com/blog/post/sustainability-esg/what-makes-esg-ratings-problematic
S&P. (2021). ESG Evaluation | S&P Global Ratings. S&P Global. Retrieved 3 December 2021, from https://www.spglobal.com/ratings/en/products-benefits/products/esg-evaluation
Sustainalytics. (2018, October). The ESG Ratings. https://connect.sustainalytics.com/hubfs/INV%20-%20Reports%20and%20Brochure/Thought%20Leadership/SustainalyticsESGRiskRatings_WhitePaperVolumeOne_October%202018.pdf