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Investors should be aware that ESG (environmental, social, and governance) ratings lack consistency and tend to be adjusted too slowly to be of much use to fund managers, according to Luke Barrs of Goldman Sachs Asset Management (GSAM).

Ratings providers often only react after “suddenly something emerges,” and “that’s too late for those investors exposed to that company,” said Barrs, GSAM’s head of fundamental equity client portfolio management in EMEA (Europe, the Middle East and Africa) and Asia ex-Japan, in an interview. There’s also “huge subjectivity that goes into how you can determine the quality of ESG practice,” he said.

Such shortcomings in the ESG ratings industry mean active managers are better off doing their own analysis of ESG risks, Barrs said. For passive managers tracking indices, however, there are advantages to using ESG ratings, “at the margin,” he said.

As questions around the quality of ESG ratings continue to surface, regulators are starting to weigh in. In the EU, where ESG regulations are further advanced than in other jurisdictions, the European Securities and Markets Authority is engaged in a review of the ESG ratings industry and is expected to recommend later this year how best to start policing it. 

Regulators that target the area will be wading into a field that’s mushroomed in tandem with the ESG asset universe, which Bloomberg Intelligence estimates now exceeds $40-trillion. There are more than 600 ratings, rankings and data providers, as well as standards and frameworks trying to measure ESG-related risks, according to the European Banking Federation.

Climate activists have also started to weigh in. The non-profit 2 Degrees Investing Initiative this week sent a poll to readers asking, among other things, “Do you think we should abolish ESG ratings?” Jakob Thomae, executive director of the initiative’s German office, said the results of the poll will inform its response to the EU’s consultation on ESG ratings. 

And financial analysts are studying ESG ratings to figure out whether investors who use them are any better off. In a recent client note, researchers at Jefferies concluded that ratings provided by MSCI may have an impact on share prices.

Jefferies found that in a universe comprising the wider market, upgraded stocks in six sectors outperformed their respective segments on a 12-month basis. An equivalent analysis of stocks downgraded by MSCI showed underperformance across eight sectors. Short term, the effect was more limited, the analysts said.

A spokesperson for MSCI said its ratings are designed “for one purpose: to measure a company’s resilience” to ESG risks. Its methods may differ from other providers’ because “investors look for a diversity of opinion from ESG rating providers, an ability to hold an opinion against the herd,” rather than “simply a weighted average of industry views.”

Asked whether it would make sense to regulate the ESG ratings industry, MSCI said it has “over 13 years of experience in assigning ESG ratings and operating to the highest standards of ethical conduct in our business operations.” Regarding issues such as transparency and potential conflicts of interest within the wider ESG ratings industry, MSCI would “welcome the development of voluntary principles of conduct,” the spokesperson said.

Barrs at GSAM said a concern is that ESG ratings tend to rely on incomplete data that can be subject to bias from the companies providing it. Companies might be aware of a specific risk, but then use a disclosure model that ultimately “masks that issue,” he said. 

“And so, if you look at the ratings of those companies in the big rating providers, they actually scored fairly well,” he said. “It was only when those issues came to light, suddenly they rerated downwards materially.”

“But that’s too late for the investor who is exposed to that position,” he said. “Because the stock price has already reacted quite considerably.”

Bloomberg News. For more articles like this please visit Bloomberg.com


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