One ESG rating to rule them all?

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This note from Florian Heeb caught my eye:

One ESG rating to rule them all? The latest version of our paper, “The Economic Impact of ESG Ratings,” is online. A new analysis:

We test how strongly five major ESG ratings correlate with the holdings of ESG funds in the US ( MSCI, Sustainalytics, S&P Global, Moodys & ISS). Although anecdotal evidence suggested that many ESG funds use MSCI, the results surprised my coauthors Florian Berg and Julian Kölbel and me. If we control for the remaining ESG ratings, only MSCI shows a significant correlation with ESG fund holdings. Our finding holds if we add a series of firm-level controls and industry-fixed effects.

Also, MSCI’s importance for ESG fund holdings has increased strongly over the past few years. As shown in the graph, the correlation coefficient has increased by a factor of three since 2018. So is there one ESG rating to rule them all? Well, that strongly depends on your perspective and your aims.

For firms:
For US companies aiming to optimize their appeal to ESG funds: probably yes. If the target is to get one’s shares bought by US ESG funds, MSCI is the rating to focus on. As we show, an improved rating may even be rewarded with improved valuation. And it’s certainly easier to focus on one rating agency than on several. Especially given that they often contradict each other. But then, does it make sense to focus a firm’s sustainability strategy on optimizing an ESG rating? If a firm is serious about sustainability, it may make more sense to consider which sustainability issues are material (for both profits and the planet!) and work on these. MSCI covers over 8500 companies. For an individual firm, MSCI is unlikely to make a better judgment than insiders with deep institutional and sectoral knowledge.

For investors:
For investors that want to integrate ESG considerations in their investment processes: No. There is no such thing as a “real ESG performance.” Different ESG ratings measure different things loosely grouped around three (ambiguous) letters. Some (like MSCI) purely focus on how ESG risks affect future cash flows. Others focus more on how companies affect people and the planet. Some rate relative to industry peers, while others apply the same scale to all companies. So, it is crucial to evaluate which provider is the best choice for a specific strategy. Our findings suggest that ESG ratings are mostly used to cater to investors’ values rather than for evaluating financial risks. In my view, this is completely fine. But in this case, does it make sense to use an ESG rating with a complete focus on financial materiality? Or would an ESG rating that focuses on value alignment make more sense?

Important disclaimer: The picture might look entirely different outside of the US. We are currently exploring the role of different ESG ratings in Europe, and beyond.