By Carine Smith Ihenacho, Chief Governance and Compliance Officer and Compliance Officer, Elisa Cencig, Senior Advisor in Corporate Governance and Christopher Wright, Head of ESG Risk Monitoring.
- ESG ratings can be a useful source of information for investment, risk monitoring, and stewardship activities; however, insufficient transparency about key design choices and methodologies currently limits their value.
- ESG rating providers should disclose their methodologies, data sources and use of estimation; they should also explain the objectives of the ratings and the approach they adopt to financial and/or impact materiality.
- Providers should have internal quality and risk management controls, adequate resources, and processes for engaging with rated entities. They should also manage and disclose conflicts of interests.
Background and relevance to us as a long-term financial investor
Norges Bank Investment Management is a long-term global investor. We consider our return to be dependent on well-functioning markets and sustainable development in economic, environmental and social terms. ESG ratings are used in the market to build ESG-specific investment strategies and products, and many companies adjust their policies, practices, and disclosures to earn or retain high ratings. As such, ESG ratings impact the markets we invest in.
We are a user of ESG ratings and have an interest in a well-functioning global ESG data market. As an investor, we need information on companies’ exposure to sustainability risks and opportunities, how these are managed, and relevant performance metrics. We do not use individual ESG ratings directly to make decisions on investments, risk management, or voting. However, we use them in combination with other information to make informed judgments. For example, we have built internal models to support our monitoring and analysis of ESG risk in the equity portfolio which draw on various ESG ratings and their underlying data points. Overall, we stand to benefit from a market in which ratings’ objectives and methodologies are transparent and clear.
ESG ratings are composite scores based on environment (E), social (S), and governance (G) information related to a company, financial instrument, or product. A rating usually takes the form of a numerical score within a given range, or a letter grade as used for credit ratings (AAA to CCC). They are based on proprietary methodologies that assess information disclosed by companies, news related to ESG controversies, and other third party ESG data. These methodologies broadly involve the following steps: (1) defining which sustainability issues are material to the rated entity; (2) collecting and assessing related data; (3) converting data points into scores and weighting them to calculate an overall rating. However, specific methodologies differ considerably in the scope of the issues assessed, the choice of data points, and the weighting factors. Providers use a variety of data sources including companies’ own sustainability reporting and third-party data, but often estimate data points or use industry averages when data is unavailable. Reliability of data inputs can also be an issue, given the infrequent assurance of sustainability reporting.
The industry is currently dominated by global ratings providers: MSCI, S&P Global, ISS, Moody’s, Morningstar, and FTSE alongside smaller providers with regional or specific offerings. These providers offer ESG ratings beside a range of sustainability-related products and services, including raw data, screening and advisory services, indices and benchmarks. ESG ratings are usually paid by investors and used for a variety of purposes, including portfolio-wide analytics and risk management, ESG risk integration, stewardship, product and benchmark creation. ESG ratings assigned to a given company can influence its cost of capital and whether it is included in ESG-themed mutual funds, exchange-traded funds, and indices.
Research has found low correlation between ESG ratings issued by different ratings providers. This diversity of ratings, which can be positive, is not surprising given the diversity in assumptions, objectives and methodological approaches that inform them. Ratings may consider ESG-related financial risks and opportunities to the company (financial materiality), the company’s impact on the environment and society (impact materiality), or both dimensions (double materiality). Moreover, issues which might be financially immaterial to a company or industry today can become material in the future (dynamic materiality). Similarly, some ESG ratings assess a company relative to rated entities in its industry, whereas others compare it to all rated entities across all industries. As such, ESG ratings are best understood as external opinions based on subjective judgments, rather than objective measures drawing on the same set of facts.
Key recommendations for ESG ratings
1. Transparency and disclosure
ESG rating providers should publicly disclose their methodologies and processes, including their data sources, their estimation models including their accuracy, and weights used to generate overall ratings. Users should be able to change model assumptions from the default industry averages. Providers should be transparent on substantive changes they make to their methodology, and explain the impact they have on the quality, coverage, and distribution of ESG ratings. When sourcing data from corporate disclosure, externally assured data should be used whenever available.
Insofar as ESG ratings impact asset pricing, lack of transparency can create risk. Better transparency around ESG ratings could enhance pricing efficiency and the well-functioning of markets. We welcome steps towards regulation and encourage harmonisation of policy initiatives based on the global principles developed by IOSCO.
2. Rating objective and approach to materiality
The approach taken by rating providers is often not apparent to stakeholders, especially investors who buy ESG investment products. This can cause market participants to misinterpret ESG ratings, which in turn may lead them to incorrectly price financial instruments or create products that do not meet the expectations of customers. ESG rating providers should provide sufficient information to enable users to understand the ratings’ intended purpose, approach to materiality and whether each company is assigned a rating on an absolute scale or relative to a peer group. In the latter case, the constituents in the entity’s peer group should be disclosed.
ESG rating providers should have policies and procedures in place to manage conflicts of interest, and functional separation of business units providing advisory services to rated entities. ESG rating providers should be transparent about their governance and resources, including funding models and fee structures. Internal controls should be adopted to ensure integrity of data sets and methodology application, and adequate resources to ensure quality of ratings. The use of artificial intelligence in data estimation, quality assurance, and analysis should be disclosed.
ESG rating providers should provide rated entities with an opportunity to correct any factual mistakes contained in the published explanation of their ESG rating. They should collect information from publicly disclosed reports rather than ad-hoc questionnaires whenever possible, to avoid unnecessary complexity and reporting burden for companies. Rated entities should be encouraged to publish the data provided to rating providers, where this information is not available in public reports.
4. Developments to watch
The market and regulatory standards for ESG ratings are evolving rapidly, and our view may change accordingly. We will play close attention to the following:
- Regulatory developments on ESG ratings, such as legislative initiatives, and adoption of best practices across key markets.
- Introduction of mandatory sustainability disclosure requirements, which can result in more reliable and comparable data inputs for rating providers’ methodologies.
- Monitoring research and market driven developments such as consolidation between providers or rated entities.