Third-party ESG ratings evolving for investor needs

As institutional investors increasingly demand that money managers integrate environmental, social and governance factors into portfolios, third-party ratings used to inform decisions are under development, evaluation and in some cases reconstruction.

Money managers have at their fingertips analysis, data and overall ESG scores to help them evaluate thousands of companies. These scores come from a variety of providers, from broader coverage across the entire spectrum to more specific evaluations, such as those focusing purely on climate change.

These scores are used not only by active money managers to help with investment decisions but also in the creation of exchange-traded funds and other index-tracking strategies.

Now, the proliferation of ESG strategies is bringing more attention to these ratings. Assets invested in global ESG ETFs and exchange-traded products increased 6.8% to $22 billion in August, show data by ETFGI LLP, London.

A number of money manager sources say that much ESG data is backward-looking and is skewed in some cases toward certain regions. Therefore, they're choosing to work in different ways to incorporate and enhance these ratings.

These limitations are acknowledged by the providers themselves. Sustainalytics has for the past three years been working on new methodology, addressing some of the core areas that clients repeatedly bring up and working to capture new information, said Diederik Timmer, head of client relations at Sustainalytics in New York.

Also, for the past year or so, the firm has been working harder to keep its data fresh. "For us, it is really important the information we have on company management is accurate and up to date," something particularly important for smaller companies that may not update that frequently.

"And as part of that, we also send our research to companies and ask for feedback — that gives the company an opportunity to give us information that we couldn't find, and also is a quality check," he added.

Other providers also recognize the need to keep developing. MSCI Inc. is in contact with both active and passive managers, said Guido Giese, executive director, applied equity research at MSCI in Zurich. "There are close to 80 ETFs tracking MSCI ESG indexes, and increasingly active managers are integrating ESG ratings into their strategy as they understand its use as a proxy for how well companies are managed. Poor ESG ratings are viewed as a reason to be cautious, as they incorporate this additional information into the stock selection process," he said.

And for ESG and sustainable finance to truly scale up, "we need to address some of these concerns head on," said Lauren Smart, London-based managing director, global head of financial institutions business at Trucost Ltd., an arm of S&P Global Inc. "Some of that is to do with the ratings and data, and some education around what the data is and isn't telling you, and how ESG funds are constructed," she said.

Ms. Smart said the challenge is that a lot of data — maybe 100 data points covering different variables — are wrapped up in a single ESG rating. "But sometimes what could be considered most financially material could get lost in the noise."

Trucost executives have identified a number of emerging investor requests, such as the need to create data in the absence of disclosure in private markets and coverage beyond listed equities.

"We buy these third-party ratings, but we've always used them as a starting point," said Jessica Ground, London-based global head of stewardship at Schroders PLC. She said one reason is that academic evidence shows materiality is an important aspect of company analysis and ESG "and can vary from company to company even within the same sector, so that is hard to capture in a single number," she said. A more nuanced approach is needed, similar to that taken in credit investing, she added.

Other money managers have also recognized that the ratings are better used as a beginning for making their own decisions.

"Third-party research providers do exactly what we've asked them to do — 20 years ago we were hammering for better information for screening — they provided that," said Cindy Rose, Edinburgh-based head of ESG investing-clients and products at Aberdeen Standard Investments. "They send out a questionnaire, put together what has become an unbelievably powerful tool of readings on companies. But I would stress it's not the ESG integration perspective, and that's because they don't have the resources in place to do holistic materiality assessments. If they use an ESG matrix, it looks like every company in the same sector has the same (issues and attributes). They only do what (was) asked by clients and look at data points and come up with a score."

"We started with Sustainalytics 10 years ago and realized MSCI was producing different ratings for the same security — that slightly undermines the process," said Michael Lewis, London-based head of ESG thematic research at DWS AG. "How do we persuade portfolio managers to look at this process if there are different marks?"

The firm imports data from seven providers, which is supplemented with non-governmental organization data and cross-checked. These are the "primary drivers of our own internal rating system," Mr. Lewis said.

Coverage can also be an issue. DWS gains universal coverage from three providers and then feeds in data for other areas from more specialist firms. It is about to bring on another firm, Four Twenty-Seven Inc., Berkeley, Calif., which evaluates physical climate risk to a particular location or asset. At the time traditional data providers said they couldn't provide information DWS and its clients were searching for.

More recently, DWS has been looking at the U.S. municipal bond market, which is not covered by any of these data providers. "But my colleagues tell me there are a lot of companies out there trying to really compete with the MSCIs and Sustainalytics — these new datasets are incorporating smart data and big data to capture forward-looking risks. I think the data providers have got more competition coming — it's only in the last three years or so that people have started to see an opportunity (here) as a lucrative area for data providers."

UBS Asset Management also takes data from a number of sources to inform its rules-based approach to ESG strategies.

"It is a challenge that anyone in a rules-based environment faces because you're dealing with data," said Christopher Greenwald, Zurich-based head of sustainable investment research and stewardship at the firm. He said sustainability information is generally reported in key performance indicators and metrics from companies, from disclosures, or reported information on controversies that are in the public domain. "That is all historical. In rules-based (approaches you) don't have an analyst or portfolio manager to provide forward-looking analysis which differentiates."

So UBS executives think about putting the data together "in a more intelligent way to capture some of the forward-looking insights you can get from a team." He cites the firm's climate-aware strategy, which approaches climate change risk on a forward-looking perspective, "because most of the indices on the market are simply reducing the CO2 footprint right now." While that's an important first step, it does not address climate risk in 10 or 15 years' time, he said, and so UBS built from available data to create a "glidepath probability score," which also considers the trajectory of change in a company's CO2 emissions over time.

And on the fixed-income side, BlueBay Asset Management LLP last month rolled out its proprietary ESG evaluation process. "We use the third-party data as a starting point and overlay (that) with what we think is important," said My-Linh Ngo, London-based head of ESG investment risk. "(We) come up with our own internal scores, which we have ownership and accountability for."