How accurate are social and environmental investment ratings?

The American Council for Capital Formation says current ESG ratings are “subjective, inconsistent and lack standardization.”

Since few asset managers have the resources to do their own in-house research, they increasingly rely on third-party providers to determine the course of their investments. (Photo: Shutterstock)

A new report from the American Council for Capital Formation is challenging the quality of environmental, social and governance (ESG) ratings provided by four ratings agencies, arguing that they are “subjective, inconsistent and lack standardization.”

According to a Nasdaq report, Morningstar data indicate that 70 percent of investors are interested in socially responsible investing, and millennials even more so at 80 percent, so it’s not likely that ESG is going to go the way of the dodo any time soon. However, ACCF’s report assesses the four major ESG ratings agencies, MSCI, Sustainalytics, RepRisk and ISS Environmental & Social Quality Score, and finds them wanting.

Related: ESG interest among institutional investors growing, but segmented

The importance of the quality of ESG ratings is rising as “ESG rating services are now used by many of the world’s largest investment firms, including BlackRock, State Street Global Advisors, and many others,” the ACCF report says, with “MSCI, a leading provider of ESG ratings, claim[ing] to provide ratings for 46 of the top 50 global asset managers.”

The growth of ESG ratings, it adds, “is the result of asset managers signing the United Nations Principles for Responsible Investment (PRI). PRI, which as of 2017 had 1,800 signatories, encourages asset managers to incorporate ESG factors into their investment decisions.”

And since few asset managers have the resources to do their own in-house research on the companies in which they invest, they increasingly rely on third-party providers to determine the course of their investments.

The importance of reliable standards probably can’t be understated, particularly since Nasdaq cites a Wall Street Journal article stating that “during December 2016, one month after the election of Donald Trump, a staggering $2.1 billion flowed into U.S. equity sustainable funds, representing a 3.5 percent increase in the category’s total assets under management as of Nov 1.”

Nasdaq adds, “Since the U.S. election, as much as $8.1 billion has flowed into these funds, marking a 13.1 percent surge in the assets under management from the start of the 2016 presidential election. The Wall Street Journal article noted that this inflow has been the largest percentage inflow into any class or style of fund.”

However, according to the ACCF report, its findings indicate ratings disparities “due to a lack of standardization, inconsistencies, and subjective interpretation influenced by a number of biases—including company size, geography, and industry-specific criteria.”