Right out of the gate, it is important to clarify language around this topic so that we can be precise. I find that people often use the language of ESG ratings as a very broad term when discussing ESG research and may include the much larger landscape of ESG disclosure frameworks. To be clear, my focus here is on the narrower field of organizations that provide some kind of rating or ranking of a company based on ESG. These ratings may be relative to a peer group or can be absolute in nature based on the company’s industry profile and ESG performance.

The Role of ESG Ratings

The evolution of ESG as part of the financial industry has been on fast forward in the last few years. With this have come many other players in the form of ESG research and those who provide company ratings or assessments. In the last five years alone, we have seen some consolidation in this space, with Morningstar purchasing Sustainalytics, ISS buying the climate data division of South Pole Group, and Moody’s acquiring Vigeo Eiris – just to name a few transactions. While the overall ESG data market reached US$1 trillion in 2021, ESG ratings are dominated by only three players – MSCI, Sustainalytics and ISS ESG – with about 60% of market share.

This is in addition to the role of data aggregators such as Bloomberg and Refinitiv. On these platforms, investors are generally sourcing raw ESG data, but they can also source ratings from many third-party providers.

For large institutional investors, these research providers are an important feature of the investment landscape. The role they play may include the following:

• Numeric inputs into quantitative models;
• Qualitative or quantitative inputs into fundamental research; and,
• Research for company engagement and voting activity (fulfilling stewardship responsibilities).

Not all investors are the same, so how they use ESG data will vary based on their size, investment strategy, capacity to engage and where ESG sits in the organization. At the same time, it is important to realize that all ESG ratings providers have different methodologies, so understanding the underlying drivers and assumptions is also important for both companies and investors.

ESG Akin to Sell-Side Research

Although there has been criticism recently on how ESG ratings are not correlated with one another, this is based on a fundamental misunderstanding about the role of ESG in the investment process. Rather than view it like a credit rating that assesses credit quality, think of it as an opinion from a sell-side research analyst. These analysts can have different views of a company, and this is what makes the market interesting. A variety of views and opinions makes for a healthy market overall. It is worth noting that sell-side research has improved a great deal over the last few years by including ESG data points and this trend is likely to accelerate in the next five years. We would never expect all equity analysts to agree with one another on a company’s outlook so why would we expect this in the world of ESG?

Most investors with whom I interact do not simply plug an ESG rating into a model and make a buy/sell decision based solely on this. Similarly, we would never pick up a sell-side research report and buy if the recommendation is outperform, or sell if the rating is underperform. We use the information as one input but do our own research, try to understand how the conclusions were arrived at, compare the rating to other research and look for outliers. Obviously, other types of investors might do things differently, but it is our responsibility as investors to assess the quality of the service we receive from ESG ratings providers and act accordingly.

Practical Steps for Issuers

Know Your Investors – Ask them which ESG data they use and how they use it. This not only tells you which ESG providers you should pay the most attention to but also guides you to the ratings providers with which you should spend the most time. There is no need to answer every survey or questionnaire you receive; be selective but know your investors before making those selections.

Track ESG Fund Flows – These numbers are readily available and will help your company focus on which ESG indices are gaining the most traction and if you are included in them. Based on this, you can determine which methodologies and data points are most important, as funds and ETFs are important sources of passive capital.

Watch for Data Quality Issues – This goes for ratings providers but also data aggregators. Opinions may vary, which is expected, but the underlying data should not. Companies engage with sell-side research analysts, and you can do the same with ESG research providers. 

Disclose More Quantitative Data – Investors generally like hard numbers and this is also true when it comes to ESG. Having performance data to back up your contextual narrative goes a long way toward proving your policies and processes are having the desired outcome. Data is harder to refute than qualitative opinions and more difficult for ESG raters to ignore when assessing a company.

ESG Ratings Are Not Going Away

This part of the market continues to evolve, with investor interest in ESG growing year over year. Although the system is not perfect, ESG ratings and their providers are not going away and are likely to continue to have influence with the investor community. Adopting a distinct strategy to understand and engage ESG ratings providers is the best approach, enabling you to be proactive rather than reactive to the market and your investor base.

Jennifer Coulson is Vice President, ESG, Public Markets, at BCI.