In May 2022, the S&P 500 ESG Index underwent its annual rebalance to reflect changes in constituent Dow Jones Index ESG Scores. Tesla was among the companies dropped, leading Elon Musk to protest on Twitter that “ESG is a scam” and that S&P had “lost its integrity.” While Tesla’s garrulous CEO argued that his company should be celebrated for climate leadership, S&P responded by pointing out what ESG experts already knew: these ratings are based on more than one dimension of sustainability.

Corporate ESG ratings endeavor to evaluate a firm’s performance on environmental, social, and governance factors. These ratings are used by investors and other stakeholders in different ways—to screen out unwanted stocks, to assess non-financial risks, to build thematic portfolios or funds, and to inform civil society campaigns. The challenge for raters has been to select the datapoints, metrics, and signals that can be distilled into each rating and to construct robust methodologies to reliably analyze information inputs.  

The Rate the Raters Project

Today, scrutiny of ESG ratings is intense, and neither the companies being rated nor those using the ratings assume ratings capture the entirety of corporate sustainability performance. Since 2010, Rate the Raters (RtR) – a project of the SustainAbility Institute by ERM – has studied what corporate sustainability leaders and institutional investors really think about ESG raters. The results of the latest iteration of this study, which is kicking off this month, will be more crucial than ever. 

Each new installment of RtR encompasses:

  • A series of in-depth expert interviews with sustainability leaders voicing their thoughts on the value of ESG ratings today.
  • Surveys of investors and corporate sustainability professionals to gauge current attitudes towards ESG ratings.
  • A deep dive by our research team into recent challenges and innovations in the ESG ratings space.
  • A research paper analyzing survey findings and contextualizing ESG ratings within the broader frameworks of sustainable finance and corporate sustainability.
  • Webinars for survey respondents to discuss the research findings with ERM’s subject matter experts and researchers

To accompany the opening of the RtR survey period this week, the RtR research team produced this blog to capture some of the questions surrounding today’s ESG ratings landscape including: How do ESG ratings fit into the sustainable investing movement? Who are the heavy hitters and the up-and-comers in the world of ESG ratings? How trustworthy are the ratings’ underlying data and methodology? And who, if anyone, is overseeing the raters? In a follow-up piece in the coming weeks, we will evaluate some of the challenges and opportunities currently facing the ratings industry.      

ESG Ratings and the Investing Ecosystem

As with a company’s measures of financial performance, measures of ESG performance are based on a broad range of public and non-public information about a company and its industry. As investor demand for and use of ESG ratings has intensified and grown more sophisticated, ESG ratings have relied on ever-more complex data and algorithms.

ESG ratings agencies insist that companies that score well are those that have assessed their own risk profile and anticipated future ESG-related risks and opportunities with the intention of creating and preserving long-term value. However, recent research shows that this is often not the case, and that a company scoring well on one sustainability dimension with one rater can score badly on that same dimension with another.

To a large extent, increasingly critical analysis of ESG ratings is tied to the rise of ESG-focused investment strategies. There has been exponential growth in capital inflows directed towards sustainable finance, with asset managers earning $1.8b in fees from sustainable investment funds in 2021, a 64% increase year-over-year. Industry observers forecast global ESG investments, currently hovering around $41t, to surpass $50t and account for a third of global assets under management by 2025.

Quotation mark ESG ratings providers are going to have to grow up fast. Investors are more savvy, their needs are more broad and deep. Competition will be sharp; we may see a few years of real intense competition and a few good winners come out at the end. Quotation mark

Mark Segal

Founder, ESG Today

Behind the Curtain: The Firms that Generate ESG Ratings   

While a handful of giant firms dominate the ESG ratings market, a vast array of data providers, including rated companies, feed information to those firms as well as directly to investors and other stakeholders. Institutional investors increasingly tap the data and research underlying ratings to create bespoke assessments of corporate ESG risk and sustainability performance. More than half of institutional investors in a 2021 survey report that they already use more than one ESG data and research source in their investment decisions, with 28% percent of those surveyed anticipating that in the next two to three years they will use six or more.

As sustainable investing grows more sophisticated and diverse, investor expectations for the quality, range, scope, and frequency of ESG ratings have increased. Major ESG ratings agencies have adapted their processes and products to respond to clients’ evolving demands. This has meant both deepening the complexity underlying existing ratings products and developing new ratings tailored to meet emerging specialized investment approaches.

To a great extent, ratings giants have relied on mergers and acquisitions to meet evolving client demand. Some acquired ratings products remain standalone products like the S&P Corporate Sustainability Assessment, while other acquisitions become integrated into existing ratings such as the ISS-ESG QualityScore. 

New specialized ratings regularly emerge from independent firms and the rating giants; these ratings inform new approaches in asset screening and support themed indices. The array of specialized ratings offered within the portfolio of major ratings providers include Sustainalytics’ Country Risk Rating, the ISS-ESG SDG Impact Rating, and a range of topical ratings which feed into overall scores. Stand-alone specialized ratings include EcoVadis’ supply chain scorecards and CDP’s water security, climate, and forest scores. Along with specialized ratings,  data service providers such as the gender-equity focused Equileap allow investors to compile in-house ratings on specific sustainability dimensions.

After years on the sidelines of ESG investing, credit rating firms entered the fray and are using ESG factors in credit ratings and analysis processes as well as acquiring ESG data firms outright. Credit rating firms now generate their own ESG ratings too: Fitch developed its proprietary Sustainable Fitch platform, while Moody’s and S&P have added similar capacity via acquisitions. All three major credit rating firms also now employ ESG credit-related indicators and disclose how ESG datapoints influence credit rating analyses.

Notably, ESG ratings are gaining attention beyond the rating agencies’ traditional clientele of asset managers and pension funds, with the public increasingly able to access ESG ratings that were once available only for a fee. ISS, CDP, Sustainalytics, and S&P are among the ESG raters now allowing wider access to their ratings, which helps make those ratings part of public discourse about corporate sustainability. Beyond investors, stakeholder groups like employees and customers are increasingly alert for greenwashing, and ESG ratings, especially those released publicly, provide stakeholders with - insights into the performance, goals, priorities, and attitudes underlying corporate sustainability messaging.

Quotation mark Users like the diversity of ratings. It gives them the ability to go to a number of different providers depending on the type of information they’re looking for. The more they know about what they’re buying, the more it will help them choose to go to the relevant data provider or ratings agency that may have a more specialized approach. Quotation mark

Jean Christophe Nicaise Chateau

Legislative Officer, Corporate Reporting, Audit and Credit Rating Agencies, European Commission

Quality Data and Robust Methodology Underpin Ratings Reliability

The methodologies and algorithms used to generate ESG ratings depend on huge flows of data. This data is tied to all facets of corporate sustainability, and each datapoint is refreshed regularly as companies and markets evolve. As ESG ratings become more central to investing, the reliability of the underlying data has improved thanks to greater attention to data quality being paid by both raters and rated companies.

Perhaps the most intractable of challenges for ESG ratings has been balancing two particular attributes of ratings data: objectivity and quality. Company-furnished sustainability data is usually high quality, but may not show the entire picture and thus can fail on objectivity. On the other hand, relying on news aggregators and other external sources for sustainability data can generate inaccurate, spotty, or misleading results, and sorting out the good data from the bad can be a herculean task, which threatens quality.

ESG ratings can’t rely on only internal or external data; the best ratings often pursue the most datapoints and have the best systems to check the information gathered. Advancements in artificial intelligence (AI) are contributing to changes in ESG ratings’ data gathering processes. Using natural language processing and other tools, AI engines collect and distill information more accurately and quickly than previous data scraping approaches. The speed and accuracy promised by AI can increase the volume of resources scanned, accessing, at least in theory, greater amounts of higher quality data to feed more objective and representative ratings.

Quotation mark Unstructured data or information known to be relevant, including geospatial information, supply chain logistics, physical risk, etc., can give an indication of a facility-level resiliency to change. But it’s hard to pull the threads on this data unless you employ AI to sort through the mess. If you can sort through it then there’s a reasonable likelihood you’ve got your finger on something financially material. It’s the volume of data that is a hurdle, not if the data is material or not. Quotation mark

Todd Cort

Senior Lecturer at the Yale School of Management and Faculty Co-Director at the Yale Center for Business and Environment

While the underlying data is key, the proprietary methodologies used to create ratings are where the rubber really meets the road. For the most part, raters are reluctant to reveal the inner workings of their ESG ratings, in part because doing so could encourage corporates to try to game the system. However, some methodological openness ensures trust in the process, leaving investors confident the ratings are useful for investment decisions and helping corporates accept that the ratings they receive truly reflect performance. Perhaps as a response to recent regulatory scrutiny and increasing criticism over their role in the market, major ESG raters today are embracing greater methodological transparency.  

Regulatory Developments on ESG reporting

As the interlocks between data practices, corporate disclosure, ratings, and investment approaches become more evident, regulators are increasingly examining the ESG investing ecosystem. As part of the European Commission’s Sustainable Finance Strategy, proposed regulation meant to monitor the reliability, comparability, and transparency of ESG ratings is expected to be issued in 2023 as a part of a larger initiative by the European Securities and Markets Authority to combat greenwashing.

In the United States, ESG ratings, like credit ratings, are usually regarded as legally protected third-party opinions; regardless, tighter regulation of other facets of the ESG investing ecosystem is likely to affect ratings at least indirectly. In May 2022, the U.S. Securities and Exchange Commission released a proposed rule aimed at enhancing investment advisors’ disclosures regarding use of ESG factors in their investment practices. Provisions in the SEC’s proposed rule would require investment advisors to specify the metrics and data underlying the construction of ESG-informed funds and investment approaches, potentially increasing pressure for transparency and consistency on both data and ratings.  

Rate the Raters 2022 / 2023

As the sustainable investing ecosystem adapts to shifting investor and other stakeholder demand, evolving investment strategies, new regulation and other changes ,and, ESG raters are responding by tailoring their ratings, methodologies, and data solutions to suit client needs.

Taking the pulse of sustainability-minded investors and corporate sustainability professionals about the impact and value of ESG ratings is the purpose of each Rate the Raters effort —and we’ve never been more interested to find out what survey respondents will say. The window for the current survey is currently open: corporate issuer respondents should respond to the corporate survey, and investor respondents should respond to the investor survey.