ESG rating agencies aim to assess how sustainable companies are. The aim is to make ESG performance more comparable for investors so that they can use their money more effectively in a sustainable way. But are the rating agencies really achieving their goal?
Their judgments are feared – or coveted. They play a decisive role when it comes to a fund or index inclusion. And they are increasingly criticized: ESG ratings.
There were already over 600 ESG ratings in 2020 – and the number certainly hasn’t decreased since then. The best known are the full ESG ratings that are accompanied by a comprehensive report and assess the 360° performance of companies in terms of environmental, social and governance issues.
However, in recent years, more and more specific ESG ratings have been added – from “temperature scores” [Arabesque, MSCI] to ratings aligned with the Sustainable Development Goals (SDGs) [ISS, Sustainalytics] and monothematic ESG ratings, e.g. on “water” [CDP, ISS]: There’s an ESG rating in store for seemingly every need.
When do ESG rating agencies start rating companies?
To be rated, a company must first reach a certain size before it is targeted by ESG rating agencies. The largest rating agencies now assign an ESG rating to well over 10,000 companies each year – but many small- and micro-caps are not yet rated. For companies listed in Germany, therefore, the rule of thumb is that anyone who is at least in the S-DAX is certain to be rated by one or more ESG rating agencies.
Companies that are not (yet) at least in the S-DAX due to a lower market capitalization should not feel too safe, however. Even smaller companies may already have been rated. This can be the case when an existing larger institutional investor commissions an ESG rating at its own expense.
Zudem plant die EU, im Rahmen der Corporate Sustainability Reporting Directive (CSRD) zukünftig noch mehr Unternehmen zum ESG-Reporting zu verpflichten – Schätzungen zufolge soll die Zahl berichtspflichtiger Unternehmen in der EU in wenigen Jahren von aktuell knapp 12.000 auf über 50.000 Unternehmen anwachsen. Die neue Datenfülle wird es ESG-Ratingagenturen deutlich erleichtern, mehr Unternehmen ins Visier zu nehmen.
In addition, the EU plans to make ESG reporting mandatory for even more companies in the future as part of the Corporate Sustainability Reporting Directive (CSRD). It is estimated that the number of companies subject to reporting requirements in the EU is set to grow from just under 12,000 at present to over 50,000 in a few years. The new abundance of data will make it much easier for ESG rating agencies to target more companies.
In addition, many ESG rating agencies offer the option of commissioning a so-called “self-initiated” ESG rating for a fee. Privately owned companies and/or companies planning an IPO often use this option. The goal: to obtain external verification of ESG efforts and present it to interested investors.
How ESG ratings work
The business model of ESG rating agencies is to sell their ESG ratings to investors. To do so, they grant investors paid access to their entire ESG rating universe. To be competitive, rating agencies need to provide as many ESG ratings as they can so that investors can find ratings on as many of the companies in their portfolio as possible.
To create an ESG rating, the agencies analyze the company’s currently published ESG information. For some indicators, external ESG data sources are also used – for example, on the human rights situation in countries the company is active in. In addition, ESG controversies are included, which can lead to score deductions. The rating agencies usually find these controversies in media reports or social media news. However, only large and mega caps are usually penalized due to controversies – there’s simply more opportunity for corporate misbehavior due to sheer size.
Overview: The most important ESG rating agencies
The top dogs in the global ESG ratings market are MSCI, Sustainalytics and ISS. Not only do these three players rate the most companies, but they also possess market-relevant characteristics that increase their relevance for various investors.
MSCI is the world’s largest index provider. The indices constructed by MSCI are used by asset managers for ETFs and other investment products. MSCI also leverages its strong position in “traditional” equity indices when it comes to ESG indices. ESG ratings from MSCI are directly incorporated into numerous MSCI ESG indices, which in turn makes it easier for asset managers to use them for their own fund products without having to conduct their own ESG research.
Sustainalytics is an ESG rating agency from the Netherlands. The firm was fully acquired by Morningstar in 2020. Morningstar is an international financial services company specialized in share and fund analysis. In the field of ESG, for example, Morningstar assigns aggregated ESG ratings to funds, and can now also rely on Sustainalytics’ expertise to strengthen and expand its own range of offerings.
ISS is classically a proxy voting advisor that helps asset managers vote on their portfolio companies at shareholder meetings. For several years, ISS has developed a strong ESG pillar, acquiring the German ESG rating agency oekom Research in the process. ISS as a whole was then acquired by Deutsche Börse in 2020. Qontigo, a subsidiary of Deutsche Börse that is responsible for the DAX and STOXX indices, among others, already relies on ESG information from ISS – and the use of ISS ESG ratings for Deutsche Börse products is expected to increase in the future.
But traditional credit rating agencies such as S&P and Moody’s are also catching up in the ESG market. One advantage for them is their dominant position in the credit rating business. By integrating ESG information into credit ratings, they can offer investors financial and non-financial ratings from a single source. The seriousness of the credit rating agencies’ ESG push was demonstrated by high-profile acquisitions in 2019: S&P bought the Dutch ESG rating agency RobecoSAM and Moody’s acquired the French ESG rating agency Vigeo Eiris.
Then there are major data providers such as Bloomberg, Refinitiv or Factset that add ESG data to their huge financial databases. In doing so, they rely exclusively on algorithms and predominantly collect and evaluate only the ESG information that companies report publicly themselves.
Finally, there are the topic-specific ratings: For example, CDP is the leader for environmental ratings and Vigeo Eiris for supply chain ratings. The latter ratings can also affect companies that are not listed on the stock exchange but are part of the value chain of other companies that have to report on ESG.
Where is the ESG rating market headed?
Initial consolidation trends among ESG rating agencies indicate that the ESG rating provider market is likely to become somewhat more compact in the future. However, this does not necessarily mean that the number of ESG ratings themselves will shrink, as the major providers continue to establish new thematic ESG ratings. Those who want more clarity will therefore have to rely on stricter regulatory requirements. The European Securities and Markets Authority (ESMA) has at least recognized the problem – but the road to a solution is still long and winding.
At Via Tomorrow, we are experts when it comes to the ESG rating jungle. We are happy to support you with understanding and effectively improving your ESG ratings – get in touch!