Yet another reason not to trust ESG ratings

My qualms with ESG ratings are well documented. In my view, they lack consistency, have a large cap bias, create opportunities for greenwashing, and in the end, don’t even capture the best ESG investments around. However, a study from Columbia and Emory University indicates that there may be even monetary conflicts of interest at play in some cases.

The study compared the ESG ratings from two different providers, MSCI ESG and Refinitiv. The crucial difference between the two providers is that most of the revenues of Refinitiv come from selling data. Meanwhile, about 60% of the revenues of MSCI come from selling index licences. Could it be that the ESG ratings of MSCI are influenced by the company’s index business?

To check this, the study focused on the differences in ESG ratings for the same companies between the two rating agencies. As you can see in the chart below, these differences have not just been large but increased over time. ESG ratings convergence? Missing in the case of MSCI ESG and Refinitiv.

Difference in ESG ratings between MSCI and Refinitiv

Source: Agrawal et al. (2023).

But what is worse, it seems that MSCI ESG ratings change if the share price performance of a company changes. Companies with higher share price returns receive higher ESG ratings from MSCI than from Refinitiv. This happens despite the lack of change in ESG data and the fact that both MSCI ESG and Refinitiv use the same publicly available ESG data for each company. Furthermore, MSCI ESG ratings are systematically higher than Refinitiv’s ratings, and the inclusion of a stock in MSCI ESG’s indices is linked to past share price performance.

In essence, companies with better performance seem more likely to be upgraded by MSCI ESG and then included in the MSCI ESG indices. Companies with poor share price performance seem more likely to be downgraded and then dropped from the MSCI ESG indices. No such effect is visible in Refinitiv ESG ratings. Whether this is intentional or just coincidental is impossible to tell from the study, but one thing seems clear to me. ESG ratings should be independent of share price performance and while this is the case for Refinitiv’s ratings, it is not for MSCI ESG ratings.

MSCI ESG ratings change around index changes

Source: Agrawal et al. (2023)