Proliferating ESG indices pose dilemma for investors  

• • • ESG ETF fund volumes have soared 25-fold in five years, supported by a glut of related index launches.
      
    • Questions arise over whether investors are assessing the underlying data that these products are built on.
    • Increasing academic and regulatory scrutiny of ESG ratings could see current practices overhauled.
      

Environmental, social and governance (ESG) indices have become big business. But their stellar rise raises questions over whether their providers have the resources to properly assess the underlying data ­– especially in such a subjective area.

The number of benchmarks measuring ESG criteria jumped roughly 40% between 2019 and 2020 in line with increased demand from investors keen to gain exposure to sustainable assets, according to the Index Industry Association’s fourth annual benchmark survey published in October 2020.

This surge in available indices in turn has supported the stellar growth of exchange-traded funds (ETFs) that claim to incorporate ESG factors, both equity and bonds.

Flows into ESG ETFs in Europe, for example, comfortably exceeded flows into any other type of ETF during the first quarter of this year, Morningstar data shows. In five years to date, such funds have multiplied from 90 to almost 600 and seen their assets soar some 25-fold from $10bn to $246bn.

This trend reflects the push by the asset management industry to create more mainstream ESG investments. From what originally was a series of specialist ESG indices focusing on specific sectors – or components of the E, the S and the G – we are now seeing the proliferation of indices with a “sustainability tilt”. In other words, the same funds that everyone is used to, but with an ethical overlay.

All to the good, many would argue, as the trend raises general awareness of sustainability. But as Capital Monitor sees it, this push for more general ‘ESG-light’ investment runs the risk of merely serving a market hungry to be seen as committing to sustainable issues but not wanting to commit to the effort of establishing the real-world impact of those investments.

ESG ratings variance

The companies sitting within ESG indices are typically underpinned by ESG ratings, and there are concerns that the methodologies behind such ratings are at best unproven, and at worst flawed. The sheer number and lack of correlation between them underlines the difficulty of agreeing on a satisfactory approach.

A recent study, titled ‘Advanced Factor & ESG Investing’ and released in March by EDHEC Business School, analysed the output of six of the most influential rating agencies in the ESG space: Asset4 (Refinitiv), MSCI KLD, MSCI IVA, Bloomberg, Sustainalytics and RobecoSAM. It found that the notable variance in scores they calculated for the same entities was actually increasing uncertainty among investors and reducing their allocation to such strategies.

“Our findings imply that the lack of consistency across ESG rating agencies makes sustainable investing riskier and hence reduces investor participation and potentially hurts economic welfare,” conclude the authors. “Moreover, green firms are less likely to benefit from a lower cost of capital in the presence of uncertainty about their ESG profiles, which could further limit their capacity to make socially responsible investments and generate real social impact.”

These findings appear to contradict the huge recent increase in sustainable investment flows, but the reason for the scoring variance is crucial in understanding why investors cannot outsource all intellectual responsibility to third parties.

If asset owners, for example, are investing in funds with exposure to these indices, are they aware of the underlying ratings at all? If they were, would they be comfortable their investments were having a positive impact? It’s likely that many institutional investors – especially the smaller players – do not have the resources or inclination to drill down to that extent.

Proprietary models at risk?

All ESG rating providers have their own proprietary methodology, but the variance in scores is largely down to three main factors: the weighting, scope and measurement of categories.

For example, a rating agency more concerned with carbon emissions than human rights will assign different weights than one that cares equally about both issues. Equally, one rating agency may use different metrics to establish the performance of a company in respect of such factors and weight them differently depending on what it deems more impactful.

As the EDHEC Business School says: “The construction of ESG ratings is non-regulated, and methodologies can be opaque and proprietary, leading to substantial divergence across data providers.”

The issue is also on the radar of regulators in Europe. In a speech in October, Richard Monks, a director of strategy at the UK Financial Conduct Authority, acknowledged the risk posed by the variance in methodologies to investors.

“Significant gaps remain, and investors aren’t yet getting the decision-useful information they need,” Monks said referring to ESG ratings provision. “And across the industry there is reliance on ESG ratings. Rating providers also rely on public information, so their outputs are similarly subject to data gaps.”

The European Union (EU) appears on a similar footing. The European Securities and Markets Authority, the EU’s securities markets regulator, wrote to the European Commission in January earmarking its concern for the need to match the growth in demand for ESG ratings and tools with regulation to ensure their quality and reliability.

Expertise and resources

Unlike with traditional credit ratings, the amount and type of data needed to analyse comprehensively a company’s ESG performance is large and so far not easily sourced or quantifiable (although that should change soon, as Capital Monitor has reported). Do the rating agencies have the experience and resources to map out all the factors that can influence ESG?

Take MSCI as an example. The index provider offers at least 1,500 equity and fixed income ESG indices.

But who calculates these scores that run them? The index provider’s sustainable ratings business, MSCI ESG Research, says it has 60 full-time employees, of which 25 are ESG analysts and researchers. It boasts of measuring “key ESG risks and opportunities” for more than 8,700 companies. On a crude calculation, that would mean each analyst is responsible for analysing around 350 companies.

MSCI ESG Research does say it can “leverage” up to 250 researchers across its affiliate entities to assess ESG factors, but that would equate to nearly 35 companies per researcher – still a high ratio.

Taking responsibility for ESG indices

Some form of ESG scoring and reporting is essential, but what guise it takes should remain a matter of fierce debate.

As the Paris-based Organisation for Economic Co-operation and Development said in September last year: “Despite… shortcomings, ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation.”

Given the risks in the market about ratings disagreement, there is a school of thought that all disagreements between agencies need to be made transparent, allowing investors to make their own decisions on the back of it.

“It’s better to have the disagreements on the table, so investors know about it, can measure somehow the ESG disagreement, and from there try to take smart decisions,” Abraham Lioui, professor of finance at the EDHEC Business School tells Capital Monitor.

This requires rating agencies to provide greater transparency on their methodologies. Failing that, regulators must apply more pressure to ensure a level ratings playing field.

Given the increasing academic and regulatory scrutiny of ESG ratings and the huge political capital invested into ensuring a fairer and greener world, it seems inevitable there will be greater oversight of this area.

For investors piling into funds that track these indices, that will be no bad thing. But in the meantime, they may wish to pay more attention to the contents of their benchmarks.