Environmental, social, and governance investing is gaining popularity not only for its “feel-good” factor but also for its potential to spot financial risks that often cannot be identified in a company’s quarterly results. The threats that climate change poses to a supply chain or the scandals that could arise from a discriminatory workplace may have a dramatic impact on a company’s future performance. The trouble is these risks are hard to measure and rarely disclosed.

This presents a challenge for the insurers, pensions, family offices, and other large investors looking to improve the long-term sustainability of their portfolios. It’s also creating demand for services from ESG data companies that provide research and ratings on how well companies are addressing environmental, social, and governance concerns. “ESG data and ratings are a huge industry, as everyone will be needing it. So it’s becoming mainstream,” says Axel Pierron, co-founder and managing director at the consulting firm Opimas.

ESG scores can play a key role in determining whether fund managers or exchange-traded funds buy a stock, how much companies pay on loans, and even if a supplier bids for a contract. They can also help verify whether a bond is really “green” or if a company is eligible for a stock benchmark. Investments in about $30 trillion in assets have relied in some way on ESG ratings, according to estimates from an MIT Sloan School of Management working paper published in August. 

Yet, confusingly for investors, findings from different providers of ESG data and ratings are difficult to compare. “I would caution against relying on these ratings exclusively,” says Erika Karp, New York-based founder and chief executive officer of Cornerstone Capital Group, an impact investment adviser that has about $1 billion of assets under management.

The same MIT paper found that in a dataset of five ESG raters, correlations between scores on 823 companies were on average 0.61. (A correlation of 1.0 would equal 100%.) For comparison, credit ratings from Moody’s Investors Service and S&P Global Ratings are correlated at 0.99.

Mona Shah, director at Stonehage Fleming Investment Management, a London-based multifamily office, says she read through lots of conflicting ratings when building a sustainable investment portfolio for clients and decided not to rely on them fully. “ESG analysis, by its very definition, is subjective,” she says. “Different providers will inevitably have different ways of classifying whether they think social concerns are more important or whether they are driven by carbon footprint, for example.”

Different Weights

Competition in the ESG ratings market is heating up. At least a dozen major third-party companies do such ratings, including Sustainalytics and MSCI Inc., outnumbering the handful of companies in the credit and mutual fund rating space. Recently, S&P, Moody’s, and Fitch Ratings have gotten into the game by acquiring ESG data and ratings providers or integrating ESG analysis in their credit rating evaluations.

ESG ratings providers generally calculate scores by scouring publicly available data, including company statements, news stories, and reports from nongovernmental organizations. The themes they cover tend to mirror the 17 named in the United Nations’ Sustainable Development Goals, which range from gender equality to clean energy. 

Theoretically, the scores should relate largely to the risks associated with a company’s core business activities. In that case, how a foodmaker handles waste or what a transportation company is doing to reduce carbon emissions would be under the most intense scrutiny. However, methods for assessments vary among providers. “These methodologies take a great deal to understand, and ESG ratings providers could offer more communication to explain these, allowing for more transparency,” Shah says.

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