ESG downgrades show complicated nature of sustainability ratings

MSCI’s pending downgrades to the ESG ratings on thousands of funds is the latest quirk highlighting the murkiness of sustainable investing — but they're also part of a global trend toward tighter standards in what is and isn’t green.

Last week, the ratings firm announced that it would be nixing an “adjustment factor” in its assessment of ESG. That adjustment, which considered a fund’s exposure to companies with improving ESG ratings, gave a boost to the scores on nearly two-thirds of the mutual funds and exchange-traded funds that MSCI covers.

As a result, nearly all of the 20% of funds with the highest AAA ESG rating will lose that grade, falling to AA or lower. Currently, about a third of funds have an AA rating, and that proportion will drop to just over 22% when the new standard is applied.

“In this new era where improvement in ESG is the status quo, we believe that the threshold required to receive a top ‘AA’ or ‘AAA’ rating should be more rigorous and ambitious,” according to a paper by Rumi Mahmood, head of ESG and climate fund research at MSCI. “This is a one-time calibration of the entire universe of funds and not indicative of more downgrades to come. In effect, the goal posts are shifting, rather than any funds becoming worse as a result of their current allocations.”

Roughly 31,000 funds globally will get lower ESG scores, Mahmood wrote.

GLOBAL TREND

MSCI’s change follows downgrades followed a cull last year by Morningstar of about 1,200 European funds on its sustainable products list. That decision came amid a burgeoning number of funds making sustainability claims after the Sustainable Finance Disclosure Regulation went into effect, with those products classifying themselves as sustainable “Article 8” rather than traditional “Article 6” funds that do not consider sustainable factors.

Since then, many asset managers have eased up on their sustainability claims, with about 40% changing their designation from the most-sustainable “Article 9” classification to Article 8 in the fourth quarter of 2022, according to a report from Morningstar. That mass migration reflected wariness among fund companies of regulatory scrutiny, the data and ratings firm wrote.

In the U.S., where the Securities and Exchange Commission has proposed several rules designed to combat greenwashing, asset managers also appear to be walking back sustainability claims. In the coming years, fund names will likely be subject to ESG designations that align products’ names with how they actually invest.

A report late last year from the US SIF Foundation pegged total sustainably invested assets at $8.4 trillion, down from $17.1 trillion in 2020. While that decline was partially due to a change in the report’s methodology for classifying investments, it was also a result of money managers self-reporting smaller amounts of sustainable assets.

WHAT'S IN A RATING?

It’s well established that ESG ratings on securities and funds can vary dramatically across providers. Ongoing research updated last year by authors at the MIT Sloan School of Management and the University of Zurich found that ESG ratings on the same securities had correlations ranging from 0.38 to 0.71 among six rating agencies: KLD, Sustainalytics, Moody’s, S&P Global, Refinitiv and MSCI. By comparison, correlations for credit ratings on securities tended to be much higher, at 0.92 between Moody’s and S&P.

“This disagreement has several important consequences. First, it makes it difficult to evaluate the ESG performance of companies, funds and portfolios, which is the primary purpose of ESG ratings,” the paper said. “Second, ESG rating divergence decreases companies’ incentives to improve their ESG performance. Companies receive mixed signals from rating agencies about which actions are expected and will be valued by the market.”

That could also lead to underinvestment in sustainability improvement and markets being less likely to price companies’ ESG performance, the researchers wrote.

The inconsistency in ratings makes it difficult for investors to accurately assess sustainability and ESG-related performance, according to the paper. But it also provides fuel for a growing number of critics of ESG who, while often dismissive of the investment case for such data, have noted that it is difficult to define.

"Part of the issue is that 'ESG' covers a large number of material issues," Andrew Monte, director of digital strategies at As You Sow, said in an email statement. When ratings providers give a single ESG score for a fund, it takes into account different factors ranging from carbon emissions to political spending and diversity, equity and inclusion, he noted. And since ratings agencies weight those factors differently, scores on ESG will inevitably vary.

"This is one reason why As You Sow's Invest Your Values ratings are by issue, and we don't produce a single overall ESG rating for funds. There are downsides to this approach — investors are busy and may prefer a single rating to look at when making investment decisions," Monte said.

Further, there is not agreement among rating companies about assessing specific types of ESG risk, such as those related to utilities, where a security might simultaneously have exposure to fossil fuels and clean-energy technologies, he noted.

Another aspect of ESG information is the engagement that fund providers have with their portfolio companies. That often includes asset managers pressuring companies to improve their carbon footprints, for example. But engagement is hard to measure and incorporate into ESG ratings.

"A lot of engagement happens at the level of dialogue," Monte said. "There may be significant differences between asset managers in terms of the level of pressure they apply to companies to shift their behavior, but it's happening behind closed doors, and asset managers are reticent to disclose details beyond vague assurances that they seek to hold all companies to account on material issues."

One European ESG data provider, Impact Cubed, was quick to respond to the MSCI downgrade news, claiming that its own service avoids giving ESG ratings and instead provides quantitative analyses.

That firm criticized the changes at MSCI, saying “the downgraded scores are still far too positive,” citing the current AA rating on the Franklin Natural Resources Fund

“Our analysis shows that the fund has a net negative ESG impact of 339 basis points, with high carbon and waste emissions and nearly 70% of its revenues attributed to environmentally harmful business activities,” according to a post from Impact Cubed. “It also ranks in the bottom 1% of funds for ESG impact. This makes sense given the fund’s strategy, which has a heavy focus on energy and mining companies.”