The EU’s Sustainable Finance Disclosure Regulation (SFDR) has been a major catalyst for driving investor attention towards climate change, and deserves full credit for this. Yet it has also created incentives for ‘quick fix’ environmental, social and governance (ESG) labels and, ironically, greenwashing. Rather than overhauling investment objectives, fund managers are merely clarifying how ESG factors influence their strategy to gain an Article 8 or 9 certification. This is a far cry from the green economic overhauls that the legislation was intended to incentivise.
ESG ratings play a key role in providing evidence for fund managers to comply with regulatory requirements like the SFDR and identify financially material ESG risks. According to some academic research, 88% of investment professionals use third-party ESG ratings within their investment processes. However, our own analysis of 16 ESG rating providers – including all major vendors as well as smaller players – reveals that most ratings are currently not fit for purpose.
Issues with ESG ratings
Crucially, the ESG calculation methodology is often not transparent and decisions are made subjectively by an analyst or rating committee panel, rather than following a scorecard model like credit ratings. Some providers measure the impact of climate change on a company; others, how companies’ activities impact the environment. The ‘E’, ‘S’ and ‘G’ components are attributed different levels of importance, depending on the industry, to produce a weighted average score. The issue is that these three areas are unrelated and there is no applied science in assigning weightings.
Further, most ESG ratings are generated using unaudited company information. The scores depend on corporate disclosures, which lack third-party validation; the more a company mentions the climate, the higher the rating it typically receives. Most providers only update the ratings once a year, meaning the scores merely act as a snapshot in time, rather than a deeper analysis of a company’s business plan, historical performance, strategic vision or direction of travel. On top of this, upgrades are sometimes unjustified, without qualifiable changes to support them.
Another dilemma is that many providers only compare issuers within the same industry. An AAA score is therefore not an absolute rating, but a ‘best in class’ compared with peers, identifying sector leaders and laggards only. This makes ratings misleading because companies are not assessed on their individual environmental impact.
Ultimately, the lack of standardisation has established loopholes whereby emitters can hide their harmful activities while registering a positive ESG rating. For example, multinational tyre manufacturer Michelin allegedly used green bonds to fund new deforestation projects, yet received an AAA rating from MSCI in 2021. Under the current ratings formula, it is difficult to undertake a meaningful analysis of issuers and the environmental impact of investments.
Reforming the ESG ratings system
Many ESG rating providers have useful tools relating to data, particularly Scope 1 and 2 emissions, issuer controversies and principle adverse impacts, which fund managers should monitor under SFDR. There is clearly technology and analysis that investors can leverage, but ESG ratings need to be reformed. The net-zero transition hinges on reallocating capital to issuers whose sustainability claims stack up to their ESG credentials.
Otherwise, greenwashing will prevail as an industry-wide practice, with many funds classified as ‘sustainable’ despite doing little to benefit the planet or society. Asset managers globally are set to increase their ESG assets under management by 84% by 2026 – but over half of ‘low-carbon’ ESG funds are estimated to be exaggerating their claims. According to PwC, more than eight out of 10 asset managers believe mislabelling is prevalent in the industry due to inconsistent data standards and poor information from portfolio companies.
Ratings should be developed based on clear rules, formulae and standardised metrics. It would be logical to split them by ‘E’, ‘S’ and ‘G’, rather than bundling them together, particularly as the environmental score is the key focus for net-zero. Carbon emissions should be an input, but other factors must also be considered. This includes Scope 3 emissions and the trade-offs required to reduce emissions, such as in transition finance, whereby investment can help high-carbon companies enact long-term changes to become greener.
There is currently no perfect ESG ratings formula, although it would be possible to institute a transparent, global scorecard model. Ratings should measure the tangible activities and positive or negative impacts a company has on the environment, with a clear definition of the highest rating, irrespective of industry. This is dependent on improved reporting from companies, something which the International Sustainability Standards Board is already working on.
Regulation must reflect the increasingly diverse nature of climate funds and true activities of portfolio companies, and move away from hierarchical rankings. For example, funds could be split into those investing in green companies, ‘transitional’ companies moving towards carbon neutrality, and carbon credits, subject to auditing requirements. These categories would generate more accurate labelling from the outset and improve transparency across the industry. Upcoming UK regulation may be more aligned with this approach, but has yet to be finalised.
As the number of ESG funds grows, encouraged by regulation, so too does the importance of transparent and reliable ESG ratings. The current system is flawed and may only serve to support greenwashing practices, underhand tactics to achieve high scores and the accreditation of ‘false positive’ ESG ratings. A reformed ESG ratings industry could help end the greenwashing saga and truly support a green transition.
This article first appeared in Sustainable Views, an ESG policy and regulation service by the Financial Times Group.
Maria Lozovik is co-founder and portfolio manager at Marsham Investment Management.
