IOSCO, whose members regulate the world’s securities markets, said in November that ratings companies should provide greater transparency on how they reach their conclusions and regularly review their methodology. The European Securities and Markets Authority is currently surveying the industry ahead of likely recommendations for regulating it.

European Federation of Investors and Financial Service Users spokesman Arnaud Houdmont said Russian issuers and bonds should have been downgraded from an ESG perspective immediately after the country occupied Crimea in 2014. The Brussels-based nonprofit represents individual savers and investors.

In a recently released study, professors Elizabeth Demers, Jurian Hendrikse, Philip Joos and Baruch Lev (who recently retired from New York University’s Stern School of Business) questioned why companies were able to retain their high ESG scores after investing so heavily in Russia. Among other observations made was an absence of any statistical association between companies’ ESG scores and their exposure to Russia.

“If you’re an investor who has been picking stocks based on ESG scores under the assumption that your money is likely to be funding more socially responsible corporate behavior, you should be very disappointed,” the professors wrote.

Red Flag
Without reform, investors risk repeating the mistakes they made in Russia. For now, the method by which ratings firms generate ESG metrics are often counterintuitive. For example, Sustainalytics gives a higher ESG rating to Russia than to Ukraine (It did so before the war and continues to do so now). 

Simon MacMahon, global head of ESG at Sustainalytics, said the firm’s sovereign ratings are based on a country’s ability to manage its wealth, both in the form of natural and produced capital. The greater the wealth and the better a government handles it, the lower the ESG risk.

“We recognize that ESG ratings firms, and I think analysts of all types, really, could have been more forward-looking and perhaps quicker to raise a significant flag prior to Russia’s invasion,” MacMahon said.

Such ratings faced scrutiny even before Russia invaded Ukraine, amid wider questions as to the purpose of ESG: Is it a tool for avoiding financial risk or for improving the world? And seemingly contradictory ratings underscored the complexity of measuring environmental, social and governance factors.

The companies that provide ratings admit it’s exceedingly difficult to capture everything in a single score. To provide more guidance, ISS ESG identifies factors like human rights and free speech violations that investors can use to supplement ratings.

According to Kristina Rueter, global head of ESG methodology at ISS ESG, the onus is on fund managers and other stakeholders. The company rated Russia C- before the war, and hasn’t downgraded it since.

“Russia has long been flagged for various violations,” including its “authoritarian regime, violation of freedom of speech, violation of human rights, nuclear weapons, low scores on the global peace index,” Rueter said. “The current situation confirms the controversy assessment that we had.”

This article was provided by Bloomberg News.

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