ESG ratings under scrutiny: What is the truth behind the harsh criticism? (2024)

There are many criticisms of ESG company ratings. They are actually intended to provide scoring approaches for the evaluation of companies with regard to ESG aspects. In other words, for numerous aspects relating to the environment, social issues and corporate governance. Critics believe that ESG ratings instead tend to cause confusion and are meaningless when it comes to the informative value of companies' impact on the environment and society. But is this criticism justified? A study by Pictet Asset Management concludes: Yes, but only in part.

Two different approaches taken by rating agencies

According to the authors of the study, much of the confusion comes from a misunderstanding of the objectives of the rating agencies behind the ESG ratings. For example, those from MSCI and Morningstar Sustainalytics. These two market-dominating agencies put the spotlight on the financial substance of ESG. It is important to note that this approach does not claim that the company's services and products have a positive effect on the environment or society.

Other rating agencies try to assess the overall impact of companies on the world. The focus here is on aspects such as efforts to create access to basic sanitation. Or compliance with global human rights and labour standards. This approach is mostly followed by smaller ESG rating agencies. The assessments are particularly interesting for investors who pursue social and ecological goals.

In the study, the two routes are referred to as "stakeholder impact" and "issuer ESG risk". Both of them can provide investors with important information. They just need to know what they're getting into. There is no holistic approach to ESG rating agencies.

Methodical incompetence – are the critics right?

Probably the biggest criticism of the ESG rating agencies is the fact that they sometimes come to completely different assessments of one and the same company. This is also proven by the study authors. According to this, the correlation between two ratings for a company varies between 0.71 and 0.38. For comparison, the correlation between the assessments of S&P and Moody's is in the range of 0.96 and 0.98.

The reasons for these deviations were described in a study by Berg et al. from 2022. According to this, there are three main aspects to which rating agencies are subject:

• The ESG categories receive different weights from the agencies.
• For the agencies, there are differences in the spectrum, i.e., the coverage, the ESG criteria.
• Agencies have developed different measurement approaches. Different indicators are used and the indicators are sometimes processed differently.

The criticism is therefore justified, but the discrepancies in the measurements focus on a few ESG categories. For example, corporate management, environmental management, corruption and climate risk management. And there is hope that the assessments will converge. The experts' analysis indicates that a convergence of ratings may occur in the near future. Especially if the published ESG data of companies meet a standard. Such efforts already exist.

What can ESG ratings not achieve?

Despite all the justified and less justified criticism, it is important for investors to know what ESG ratings can – and cannot – achieve. Most rating agencies neglect the aspects relating to the services and products of companies and their contribution to a sustainable economy. Aspects that are becoming increasingly important for many investors. Therefore, they should also rely on other instruments in this area.

Rating agencies are often unable to provide clear signals to investors who wish to apply a portfolio exclusion list based on a product mix of companies. And the significance of corporate controversies such as omissions and compliance violations cannot be clearly assessed either. All these concerns are included in the ESG ratings, but only as one factor among many.

What can ESG ratings achieve?

It is equally important to know what ESG criteria can do. The experts of the respective studies agree that they can accelerate and simplify the ESG analysis. Investors can therefore undoubtedly benefit from the fact that many ESG indicators are summarised in one rating. The approach has its limits, like almost every other approach. Investors must also be aware of this.

It may be advisable for them to use ESG ratings in the same way as recommendations from investment research companies to buy, hold or sell shares. The ESG scores would thus be an investment assessment. It's as simple as that. This eliminates some of the criticism of ESG ratings.

A ray of hope: ESG regulations

For those who are disappointed by the current situation surrounding ESG ratings, there is a ray of hope. The government authorities are about to intervene. Already last year, the authorities in Japan introduced a code of conduct for ESG rating agencies. The European Union (EU) then began its own consultation, which should lead to a revision of the legal framework. The EU wants to submit a legislative proposal by the end of 2023. The British government then also wants to start a consultation. This means that criticism of the weaknesses of ESG ratings is making waves.

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