Investors betting trillions on ethically-appealing stocks may not be getting all they expect. Buying into companies based on environmental, social and governance factors, has become a hot trend on Wall Street, spawning a new industry that sells investors company ratings based on those factors and funds dedicated to rated companies. However, some investors and funds may rely too much on the scores of one rating firm, said Dan Hanson, a portfolio manager at Jarislowsky Fraser Global Investment Management.”The scores are in some cases being used in a way they are not really designed for,” Hanson said. “It’s problematic to bolt them on to an investment process.”
There are no set criteria for who is bad and who is good and so-called ESG ratings vary widely, meaning investors may be less protected than they think, for example, from a scandal over labor practices or board pay. “We don’t have a common vernacular,” said Asha Mehta, director of responsible investing at Acadian Asset Management in Boston. Sustainability analysis firm CSRHub compared such ratings given to companies in the S&P Global 1200 index by two leading firms in the field – a division of MSCI Inc, and Toronto-based Sustainalytics – and found they had a correlation coefficient of 0.32, a relatively weak level.
Credit ratings, in contrast, are closely aligned, with the comparable figure for Moody’s and S&P ratings of around 0.9, according to research by Northern Illinois University finance professor Lei Zhou. The difference is that credit ratings rely on financial disclosures while the sustainability ratings may reflect different weightings given to factors such as workers’ rights, emissions, or responses to events such as an oil spill or product failure.
Electric car maker Tesla, for example, has received a top AAA score from MSCI, but a middling grade from Sustainalytics, below that of traditional automakers Ford Motor Co and General Motors , partly because Tesla does not release carbon emissions data for its manufacturing plants. Tesla declined to comment.
In interviews, a dozen professional investors and company executives told Reuters they were frustrated by the lack of common standards, even as many praised the work of the ratings firms individually.
One remedy, they say, would be to adopt a common language and reporting requirements. Starting next year, the European Union will require companies to report on their efforts in such areas as the environment and social responsibility. In the United States, a small group of companies, such as JetBlue Airways Corp, has embraced voluntary disclosures suggested by the Sustainability Accounting Standards Board, an independent organization.
As more and more investors recognize the long-term financial benefits of good corporate governance and sustainable policies, the need for uniform criteria becomes more pressing.The Forum for Sustainable and Responsible Investment estimates that more than $8 trillion was invested by U.S. fund managers who incorporated at least some of such criteria in their strategy, up from $1.4 trillion in 2012.
CSRHub counts 17 firms and organizations that track in some form corporate adherence to environmental, social and governance standards, including Thomson Reuters, the parent company of Reuters.
At their best, rating firms can help investors avoid losses. For instance, both MSCI and Sustainalytics raised governance concerns about Volkswagen AG months before the German automaker admitted to cheating on U.S. diesel emissions tests in September 2015.“They absolutely called that right,” said Seb Beloe, head of sustainability research at WHEB Asset Management in London.
But there is also a risk that they will miss red flags because non-financial information is less readily available and open to interpretation. Simon MacMahon, who oversees ESG research at Sustainalytics, acknowledged sustainability can be difficult to define. “We’re talking about a whole host of issues here.”
Yet Linda-Eling Lee, head of ESG research at MSCI, said few executives object to its findings. “It’s only a handful of companies where we have a back and forth,” she said. Some companies take advantage of the disparities to focus on ratings that are more favorable, said Robert Fernandez, director of ESG research for Breckinridge Capital Advisors in Boston. “You can certainly see how it’s a concern that they have divergent views,” he said.
The absence of a common standard has not stopped Wall Street. While larger investment firms usually combine ratings with their own research, some funds are built largely off ratings, even if sponsors acknowledge they may be imperfect. For example, a disclosure from one of the largest, the $866 million iShares MSCI KLD 400 Social ETF, run by BlackRock and based on MSCI ratings notes among its risk factors the chance MSCI might not pick companies with the right “ESG characteristics.”
Lynn Blake, a top investment officer at State Street Global Advisors, said the divergence in ratings, while warranting some caution, may ultimately make little difference for large, diverse portfolios. “We believe they are ‘good enough,’ particularly for broad universe index funds,” Blake said via e-mail.
The case of Tesla, shows how ratings can reflect differences in approach rather than any flaws in analysis or data.
In its report, Sustainalytics acknowledged CEO Elon Musk’s goal of making Tesla’s “Gigafactory” built in Nevada entirely powered by renewable energy. Yet it still gave the company an overall score of 55 out of 100 for not disclosing data on the carbon emissions from its automaking operations. “Their lack of corporate sustainability reporting is kind of a shame, especially considering their main product is a low-carbon product,” Sustainalytics’ MacMahon said.
Similarly, MSCI rated Tesla 5.3 on a 10-point scale for “carbon emissions,” including its own operations. But that score did not dent Tesla’s overall top AAA grade because MSCI gave more weight to other factors, such as emissions of Tesla cars, said MSCI’s Lee. Ultimately the firm decides on what to focus on to make the rating more meaningful for investors, she said. “You could give three percent (importance) to lots of issues and at the end of the day, everything averages out,” Lee said.