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The Problem with ESG Rating Providers

There are many problems with ESG ratings providers. We explore them and suggest that asset managers take a more qualitative approach to ESG investments.

Environmental, Social and Governance (ESG) investments are on every asset manager’s priority list.

Such is the demand for ESG investment options, that portfolio managers across the financial sector have become increasingly reliant on the services of ESG ratings providers to support decisions into which companies they should invest their clients’ assets.

But using ESG rating providers comes with its drawbacks: a lack of consistency around the interpretation of ESG risks and opportunities, impenetrable black-box approaches, and the unresolved question of whether ESG is being considered as a risk to our planet and society or to the financial health of companies. Variability around these and other themes can lead to totally different assessment focuses – and consequently, lead to even more incoherent ESG ratings. All of this uncertainty has left many asset managers in a considerable quandary when it comes to making confident and informed ESG investment decisions.

In this post, we’ll look at some of the key ESG data challenges and how a qualitative ESG data approach differs from that of typical ESG rating providers. We’ll then explore how a deeper, more qualitative approach to ESG data can improve ESG data screening and reporting for asset managers – and lead to better ESG investments for their clients.

Key ESG Data Challenges

In the world of asset management, quality data is the foundation of all good decision-making. Yet challenges in ESG data reporting mean that asset managers often have to work with data that’s at best inaccurate – and at worst misleading.

These ESG data challenges can lead to skewed results, misled stakeholders, wasted resources and poor ESG investment decisions. So why is this still happening?

For a number of reasons…

1. The ESG data pool isn’t big enough
The more data you have, the bigger the pool you can draw from. But the fact that only larger public companies are required to report ESG data, published via their annual reports, means that the data pool that ESG researchers have access to is limited to what these larger companies decide to self-disclose.

2. Lack of consistent regulation
Although various guidelines exist, the lack of a single regulatory framework around ESG reporting is cited by valuation experts as one of the biggest ESG data issues. Some of the most popular ESG frameworks include Global Reporting Initiative (GRI), Sustainable Accounting Standards Board (SASB) and Task Force for Climate related Financial Disclosures (TCFD), and the EU Taxonomy. But without a single, universally accepted ESG reporting framework, there is plenty of space for different interpretations of how and what to report against ESG factors.

3. No universal system to verify reported ESG data
One of the biggest challenges in ESG reporting is a lack of auditing, which undermines and limits the reliability of ESG disclosure reports. This results in public reports tending to highlight only the positive contributions to ESG, while underplaying or omitting negative factors in reporting. This is the very essence of greenwashing and it is being made easier for businesses to achieve as a result of ESG data challenges around auditing.

4. ESG rating providers use different criteria to score
This is perhaps the biggest of the challenges in ESG data reporting, because it renders ESG ratings scores an impenetrable black box. Without regulation governing the assessment of sustainability requirements and performance – and every ESG ratings provider applying its own methodology – it is questionable whether any of the results they provide are truly accurate.

Let’s explore this final point in a little more detail.

When MIT’s Sloan School of Management compared the scores from various ESG rating providers, they found that the correlation was just 0.61, on average. This lack of correlation is, in large part, owing to the widely different methodologies these agencies use.

The differences in approaches among ESG ratings providers ranges from the data sources they use to the weightings given to certain considerations and the criteria against which they assess ESG factors.

Some providers like MSCI ESG Fundamentals draw from sources like financial data and, sustainability reports, while other agencies like Sustainalytics use mostly primary research and publicly available data. Meanwhile, there are other agencies that use proprietary data sources like surveys, questionnaires, and interviews.

The weightings that ESG ratings providers give to different factors also vary wildly, with some providers giving more weight to environmental factors, while others lean more towards social or governance factors.

ESG rating providers also differ in their use of the specific criteria used to assess ESG factors, with some directing focus towards a company’s carbon emissions, while others emphasise a company’s labor practices or political lobbying. This comes back to the fundamental question about what risk assessment is: risk to the environment and society, or risk to the financial health of a company?

How a Qualitative ESG Data Approach Differs from a Ratings Approach

When it comes to ESG, both quantitative and qualitative data are important to get the full picture of a company. Quantitative data is physically measurable and numbers-based. For example, it will tell you the exact amount of greenhouse gas emissions an organization produces.

Qualitative ESG data, on the other hand, can give you access to more thematic investment opportunities. Tapping into applied innovations such as water treatment technology, or avoiding companies with exposure to plastic use requires consideration of additional, more deeply informed ESG investment factors.

Qualitative analysis involves using expert judgement and analysis to assess a company’s ESG performance based on factors such as policies, practices, and performance. Crucially, it can provide a more in-depth understanding of a company’s ESG performance.

Two key characteristics of a qualitative approach to ESG data are:

1. An emphasis on the descriptive and contextual
There is a focus on providing detailed descriptions and narratives that offer a comprehensive understanding of an organization’s ESG practices and performance, capturing the context, nuances, and underlying elements that contribute to ESG factors. That means leveraging all the data we have on a company: news, filings, transcripts – and especially company websites.

2. It is interpretive and subjective
Qualitative ESG data reporting recognizes that ESG factors are multifaceted and can vary in significance across industries, regions, and stakeholders. Often involving qualitative data analysis techniques such as thematic coding and pattern recognition, it relies on interpretation and subjective analysis to make sense of data, highlighting the diversity of perspectives that contribute to an organization’s overall ESG performance.

By incorporating these elements, a qualitative approach to ESG data reporting can yield a richer, more holistic understanding of an organization’s ESG performance, capturing both tangible and intangible aspects.

Although many ESG ratings providers review SDRs and leverage qualitative information, this is often done slowly, the information is rarely updated, and is approached from a very standardized point of view.

Improving ESG Data Screening & Reporting

It is clear that ESG data screening and reporting needs considerable improvement for asset managers to feel confident about the decisions they are making over the portfolios they manage.

An over-reliance on ESG ratings providers – who, as we have seen, differ considerably in the way they interpret and score ESG factors – means that asset managers have been left with their fingers in the wind when it comes to making sound ESG investment decisions.

We need a better way…

At CID, we use a thematic approach to improve your ESG investing strategy with more structured, relevant and concise data that helps identify new investment opportunities and thematic leaders that aren’t usually found in ESG ratings providers’ data sets.

We enable asset managers to invest in applied ESG, apply their house view and provide more transparency.

Rather than applying the one-size-fits-all approach of ESG rating providers, our Affinity platform uses AI and a comprehensive and efficient screening process to tap into a universe of clearly defined and relevant companies according to the specific themes and market events your investors care about.

This yields a tailored scoring model, based on investor needs and focus areas for investment.

For more information about how Thematic Investing can support your ESG investment goals, our End-to-end Guide to ESG Asset Management is a great place to start. Alternatively, get in touch – we’d love to talk.

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