Although demand is surging, rating agencies face rising concerns from corporates and investors around data accuracy, the overall quality and usefulness of environment, social and governance (ESG) ratings, according to sustainability consultancy ERM’s latest assessment of the ESG ratings landscape – ‘Rate the Raters 2023: ESG Ratings at a Crossroads’*.
The survey, which was first launched in 2010 and developed by ERM’s SustainAbility Institute, is based on the responses from 104 corporates and 33 investors across the globe.
It found that over half of companies report that they engage with at least six ESG ratings providers.
As for the top performers, CDP was ranked by corporate survey respondents as the best ESG rater for both quality and usefulness while ISS-ESG was seen as the leader on quality.
Other ESG rating firms receiving high scores for quality and usefulness were Morningstar Sustainalytics, MSCI, EcoVadis, and Bloomberg.
The study noted that investor demand was the primary driver of engagement with ESG raters, with 57% of companies citing it as their top motivation, followed by 21% pointing to performance assessment. This reflects the growing integration of ESG ratings and data into investment strategies.
Forty-three percent of investor respondents ranked requirements by their firms to integrate ESG ratings and data into their investment practices as a top reason for using ESG ratings providers, compared with just 12% in 2018/19.
However, the report shows that over a quarter or 29% of corporates have low to very low trust that ESG ratings accurately reflect ESG performance, and 52% have only moderate trust.
Overall corporate perceptions of ESG raters’ quality and usefulness have dropped since 2018/19.
Investors polled demonstrated higher levels of trust, with 59% reporting moderate trust with 38% saying high to very high trust in ESG ratings providers.
The survey also reveals a notable trend for investors to develop in-house ESG indicators, metrics, and ratings themselves, reflecting the efforts investors have made in recent years to build their own ESG expertise.
Across both investors and companies, around half see “greater consistency and comparability across ratings methodologies” and “improved quality and disclosure of methodology” as key issues for ESG raters to fix in order to maintain trust.
ERM’s report is published against the backdrop of an increasingly dynamic sustainable investing environment.
Sustainable funds are growing rapidly, with research from Morgan Stanley showing that by the end of 2022, assets under management totalled nearly $2.8 trillion, an increase in its proportion of overall AUM to 7% from 4% five years ago.
Demand was strongest in Europe, which accounted for 89% of sustainable AUM and almost all of 2022’s net inflows to sustainable funds.
Companies are facing increased scrutiny from investors as well as regulators for greater disclosure requirements, across the European Union, US and other regions finalising far-reaching new rules.
Tom Reichert, ERM Group CEO, said, “We know first-hand how crucial ESG ratings are to spurring action on the sustainability agenda and ensuring the highest performing organizations get the recognition and financing they need.
“However our survey shows that the ESG ratings industry is at a crossroads. How raters respond to the pressures they face will determine what the field looks like in the decade to come.”
Rating agencies are reviewing their criteria and market participants are holding their breath waiting for the results of MSCI’s consultation on its ESG ratings.
According to a research note published by BlackRock iShares, the , MSCI is set to tweak several aspects of its ESG rating methodology, including removing the adjusted factor from ESG fund rating calculations and lowering the coverage requirement for fixed income funds from 65% to 50%.
In addition, swap-based funds will be excluded entirely from the MSCI ESG fund rating coverage universe.
The changes, which are expected to be implemented from Q2, could be especially significant in Europe where increasingly institutions will only invest in funds that are deemed to be compliant with ESG-investing principles.
In 2022, ESG exchange traded funds accounted for 65% of inflows into European ETFs, according to Morningstar.
The Blackrock research note said that in Europe alone, 1,476 ETFs will have a lower rating, 905 will be unchanged and 78 will have a higher rating.
It noted that 446 funds will lose their rating entirely, including more than 400 derivative-based funds.
The hardest hit will be synthetic, swap-based ETFs, which have a swap contract in place with a counterparty to replicate the performance of the underlying assets, rather than actually owning the assets themselves, like a physical ETF does.
MSCI said in its statement that “the [ESG] rating is calculated based on a fund’s underlying holdings data. In the case of swap-based ETFs, the underlying data MSCI receives in most cases is the swap collateral holdings, rather than the constituents of the underlying index that is tracked.
It added, “Therefore, we will no longer rate swap-based ETFs until we have determined a method to consistently rate a swap-based ETF based on the constituents of the underlying index that it tracks.”
In general, synthetically-replicated ETFs, have recently been called into question. Last year, the French regulator Autorité des Marchés Financiers (AMF) told investors to be “extremely vigilant” on the use of synthetic ETFs, noting the lack of transparency around the ESG characteristics.
*’Rate the Raters 2023: ESG Ratings at a Crossroads’ a report authored by Emily Brock, Senior Research & Networks Manager; Justin Nelson, Senior Research Associate and Aiste Brackley, Associate Director at the SustainAbility Institute, by ERM.
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