ESG Ratings Face Skepticism Even as Loan-Market Importance Grows

(Bloomberg) -- The corporate loan market has a new sheriff in town -- environmental, social and governance ratings providers.

ESG ratings now affect the price borrowers pay on about $32 billion of loans worldwide, up from just $3 billion in 2017, according to BloombergNEF. That’s given considerable influence to ESG graders, such as EcoVadis, Iss-oekom and Sustainalytics, which assess borrowers either against specific targets or using broad-based indexes.

Still, some investors are unconvinced by ESG ratings, citing vague criteria and conflicting grades across different providers. Citigroup Inc. credit analysts similarly highlighted in a May report how businesses in industries criticized by environmental or health campaigners, such as oil or tobacco, are able to get high ESG marks due to scoring systems favoring companies with clear policies.

Ratings attract “a healthy amount of skepticism,’’ said Erika Karp, head of Cornerstone Capital Group, which oversees $1 billion of assets. Inconsistent data and the inconclusive nature of ratings can be “quite dangerous,’’ she said. Karp is also a founding board member of the U.S. Sustainability Accounting Standard Board.

Confusing Methodology

Ratings providers generally draw on publicly available data to generate scores including company statements, news stories and reports from non-governmental organizations. General themes covered by ratings providers mirror the 17 named in the United Nations’ Sustainable Development Goals, such as gender equality, climate action and clean energy. Industry examples include waste at foodmakers or carbon-dioxide emissions by transportation companies.

These varying factors can explain differences in ESG assessments from different sources. Analysts may be focusing on specific issues or failing to adequately balance how different risks affect different industries. Air pollution, for instance, is probably of more concern at a coal-fired power station than at a law firm.

“Many assessments use a single methodology across multiple industries, which creates confusion and mistrust,” said Pierre-Francois Thaler, co-founder and co-CEO of EcoVadis. “What’s important to one business or industry doesn’t always carry the same weight at another."

Companies’ size also influence the assessment. EcoVadis for example is reliant on direct company interactions, given its focus on smaller and unlisted borrowers. Others, such as ISS-oekom, look at about 100 performance indicators per company.

Adding to the confusion, rating scales at major providers go in different directions –- 100 is the best score at EcoVadis and the worst at Sustainalytics. ISS-oekom has a 12-notch system using letters.

Another particularity in the ESG industry is that unlike with credit ratings -- where the issuer almost always pays for the assessment -- companies such as ISS-oekom and Sustainalytics either charge investors and asset managers, or have borrowers pay a license fee, which in turn allows them use ratings for different purposes including pricing ESG-linked loans.

Good Deeds

Interest in ESG-certification has given companies a public-relations incentive to increase transparency and publicize their own good deeds.

Companies can also use ESG ratings to measure progress in reaching sustainability objectives, which gives them another reason to work with ratings providers, said Bob Mann, president and COO of Sustainalytics.

Ratings have become more important in the financial world because of investors’ growing desire to channel money into products with environmental benefits. Asset managers can use ratings as an easy way of showing that funds make socially responsible investments, such as green bonds. ESG grades can also directly affect companies’ borrowing costs with the rise of ESG-linked loans. Margins in these deals can go up or down depending on ESG scores.

More broadly, ratings providers also say that ESG scores can complement financial metrics by highlighting weaknesses, such as poor governance standards, that may not appear on the balance sheet.

“Events like the financial crisis, bankruptcies and share-price slumps resulting from mismanagement or disregard of ESG risks show the limitation of financial ratings," said Kristina Rueter, executive director and head of methodology at ISS-oekom.

To contact the reporter on this story: Jacqueline Poh in London at jpoh39@bloomberg.net

To contact the editors responsible for this story: Hannah Benjamin at hbenjamin1@bloomberg.net, Neil Denslow

©2019 Bloomberg L.P.