The market for ESG investments is still a Wild West in which most of the times the law of the jungle prevails: Those who report more on ESG are also rated better by ESG rating agencies. Small- and mid-cap companies with limited resources are at risk of being left behind – unless they also start playing the ESG rating game …
Most market participants are aware that ESG factors are not yet correctly priced into most equities. This is why the ESG mega-trend is leading to more inefficient capital markets. The main reasons? A lack of data and non-financial accounting standards, making it very difficult for investors to realistically assess the ESG performance of companies.
The problem is evident in a study from Berenberg Bank: Small and mid-sized companies are being hit the hardest, receiving significantly worse ESG ratings – even though small and mid caps often take ESG issues at least as seriously as large and mega caps.
Thus, ESG ratings contribute to exacerbating ESG-related market inefficiencies. As early as 2021, the European Securities and Markets Authority (ESMA) has already identified significant problems with ESG ratings in a letter to the European Commission, pointing out a high risk of greenwashing and ESG-related capital misallocation.
Most institutional investors are also already aware of the problems with ESG ratings. Yes, they do use ESG ratings, but not so much their simplified top-line rating score. Instead, they are mainly interested in the underlying ESG data collected that is processed by the rating agencies. Take Invesco, for example: according to its latest ESG Investment Stewardship Report, this institutional investor relies on information from up to eight different ESG rating agencies. Invesco then processes this data using complex formulas to produce its own ESG assessment of companies.
The Problems of ESG Ratings: What Small- and Midcaps Should Do
What is causing the widespread distrust in current ESG ratings? The main problem is the sheer mass – both of ESG rating agencies and of the companies they already cover.
Unlike the credit rating market, where the three major agencies S&P, Moody’s and Fitch accounted for over 90% market share in the EU in 2020, the ESG rating market is still much more fragmented. As a result, there’s a plethora of ESG methodologies from hundreds of ESG rating agencies – resulting in significantly lower correlations between individual ESG ratings than is the case between credit ratings.
In terms of coverage, major ESG rating agencies such as MSCI or Sustainalytics are now rating well over 10,000 companies worldwide. Given the comparatively small size of their ESG analytics teams of just a few hundred employees, this is a big challenge – enhanced by the problem that relevant ESG topics can differ significantly from industry to industry.
Talking of industries: ESG rating agencies face very practical problems in assigning companies to the correct industry – especially since many companies sell products and services that could be attributed to different industries. Possible misclassifications can then quickly lead to a company’s own ESG rating being significantly worse than it should be.
Due to these problems, large companies are currently at an advantage as they report very elaborately already and routinely communicate with ESG rating agencies to explain their point of view. Smaller listed companies must therefore go on the offensive and themselves engage more proactively with ESG rating agencies to obtain a more realistic ESG rating – considering that ESG rating agencies often do not even inform companies that they have been rated.
Ways Out of the Inefficient ESG Market
At least there is a silver lining: the IFRS Foundation with the Frankfurt-based sub-branch of the International Sustainability Standard Board (ISSB) is striving for a fundamental standardization of ESG criteria. The ISSB, founded in 2021, is working on the development of sustainability standards for corporate reporting, which in the future should become a similar gold standard for reporting sustainability indicators as the widely used IFRS accounting standards for financial indicators.
The timeline is ambitious: the first generally applicable IFRS sustainability standards are planned to be in place in the course of this year. And if the sustainability standards subsequently experience similar widespread use as the financial standards, it is to be expected that ESG rating agencies will also standardize their assessment criteria more.
In addition, the European Securities and Markets Authority (ESMA) is working on measures to improve the reliability and comparability of ESG rating agencies to curb greenwashing. The first step was a “Call for Evidence” at the beginning of 2022, with which ESMA asked all ESG rating providers active in the EU, their users (such as institutional investors) and rated companies and sovereigns to provide details on their handling of ESG ratings.
But as long as the standardization mills of ISSB and ESMA are still grinding, companies will have to continue to cope with the chaotic status quo of ESG rating agencies. ESG ratings may not yet function ideally, but their importance for investor decisions cannot be underestimated.
We see ourselves as a consultancy that wants to make ESG markets more efficient. When it comes to ESG ratings, we are therefore the right partner for you – and will support you in achieving an ESG rating that really reflects your sustainability efforts. Contact us and learn more!