ESG ratings have become an important tool in the financial world to assess the sustainability performance of companies. However, the ESG ratings market is under increasing pressure and is drawing much criticism for opaque methods and possible conflicts of interest. In addition, there are significant deviations in the ESG ratings issued by different rating agencies, especially for individual companies.
In particular, last year ESG ratings received a bad report card when the EU Commission announced the results of a several-months-long consultation. The results were rather devastating: 84 percent of respondents questioned the effectiveness of the current ESG ratings market. The main criticisms were methodological weaknesses that led to distortions of the results (91 percent), lack of transparency (83 percent) and the presence of conflicts of interest (more than 80 percent).
Varying focuses, varying assessments
One example of such divergences is Tesla’s ESG rating. Different ratings agencies arrive at different results. At MSCI, Tesla received a good rating of “A”, while the rating of ISS ESG Corporate with a “C+” scored rather badly. In the S&P CSA, Tesla received only 28 out of 100 possible points. These differences show how inconsistent the agencies’ valuation standards are.
The deviations in the ESG ratings result in part from the different focus of the different rating agencies. Each agency focuses on different aspects of sustainability. For example, CDP Climate Change focuses on climate issues, while MSCI examines a predefined selection of six relevant sustainability aspects. On the other hand, ISS ESG is trying to map the entire sustainability spectrum. These different focuses lead to different assessments.
Challenge of data provision by the companies
For small caps and mid-caps in particular, obtaining data for the ratings poses a challenge. Large corporations such as Daimler and Nestlé publish massive amounts of data that can be evaluated by the rating agencies. Smaller companies, on the other hand, have often published less information and cannot use the same resource capacity. This means that these companies are on average rated worse in terms of sustainability.
In addition, the questionnaires of the rating agencies burden companies, especially the small caps, enormously. Participation in ratings requires high expenses and resources that many companies shy away from. Often the questionnaires are standardised and offer no possibility for an individual analysis and evaluation of the companies. This leads to an additional burden for the companies.
Possible consequences for companies: negative reviews
The optics group ISRA vision from Darmstadt became the victim of the so-called Large Cap Bias. That is to say, rating providers tend to give negative reviews if they do not find information on certain sustainability criteria or if they receive negative reviews from the companies. Such a procedure massively discriminates against companies that cannot provide the desired information – for example, small cap companies in particular.
So Isra Vision received the worst possible evaluation of ISS ESG – a “D-“. This was because Isra Vision had ignored a request from ISS ESG to participate in creating a rating. Isra Vision objected to the evaluation “D-“, and the matter went to court. In court, it was found that the areas criticised by ISS ESG were irrelevant for the company. The court ruled that ISS ESG was not allowed to evaluate Isra Vision with the worst grade, i.e. “D-“. It was emphasised that a company should not get a bad rating just because certain information is not available, and that the analysis criteria must be closely linked to the business.
There is growing criticism of ESG rating agencies and ESG ratings. The non-transparent methods, conflicts of interest and significant deviations in the evaluations are central points of criticism. In addition, small caps and mid-caps in particular face major challenges in obtaining data. Questionnaires from the rating agencies place an additional burden on companies. There is an urgent need for the ESG ratings market to become more transparent and facilitate comparisons across the market, in order to strengthen investor confidence and enable an effective assessment of sustainability performance.
“Der ESG-Ratingmarkt steht unter Druck. Kritikerinnen und Kritiker werfen den Ratingagenturen intransparente Methoden und Interessenskonflikte vor.” [The ESG ratings market is under pressure. Critics accuse the rating agencies of non-transparent methods and conflicts of interest.] (Background – Tagesspiegel)