What is the point of ESG ratings?

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Environmental, social and governance ratings have been lambasted as unreliable, opaque and poorly correlated to share price performance. This is not just a problem for the investors who follow them. As Norway’s giant sovereign fund Norges says, imperfect sustainability indicators queer the pitch for everyone else too.

Big investors do not all track the ESG ratings assigned by the likes of MSCI, S&P Global and Morningstar’s Sustainalytics. Most cherry-pick from the reams of data on offer and integrate the information into their own valuation frameworks.

But the ratings still move a lot of money. Funds with $121tn of assets have signed the UN’s Principles for Responsible Investment, pledging to take ESG issues into account when deciding what to invest in. Many use third-party assessments. Smaller investors, with less capacity for independent analysis, tend to rely on ESG ratings, or invest in products and strategies built around them.

That is a problem. ESG rating providers scrape data of varying quality from a variety of sources. This is fed into models that calculate a composite score. Providers such as MSCI publish their methodologies, which seek to give greater weight to information that is material for the company at hand. For oil and gas explorers, for instance, carbon emissions count for 19 per cent. But the amalgamation of different metrics means the final score can feel arbitrary.

That is borne out by the fact that providers score companies very differently. A paper by the European Securities and Markets Authority quotes studies estimating a level of correlation of 60 per cent. Credit ratings, by contrast, are up to 99 per cent correlated, meaning that one company will receive broadly the same view whether one consults Moody’s, S&P or Fitch.

Determining sustainability risks is, therefore, more akin to scrutinising tea leaves. Indeed, it is not clear that the companies that have a high or improving ESG score — and, therefore, a lower or improving risk profile — outperform. It rather depends on time periods and the precise methodology of different funds. But, by and large, ESG indices that track US companies highly rated on ESG terms appear to hug the main S&P 500.

Some jurisdictions are moving to redefine ESG ratings. In the EU, funds can only be labelled as “green” if they invest in companies that follow the bloc’s own rules for clean investment and operations. Regulators around the world, including in the UK, are working to improve methodologies and transparency.

Yet the very concept of a broad-brush industry “methodology” lends itself to imperfect results. The future, surely, will rest on rating agencies providing reliable raw data that investors can then integrate into their view of a company’s prospects.