The ESG rating shakedown is here
According to an article published on Friday by the Financial Times, MSCI is preparing a mass ESG ratings downgrade – with over 1,476 funds having their ESG rating downgraded and hundreds losing their rating altogether. And that’s only across Europe – the global figure could be in the thousands.
The news has sparked questions and concerns about the impact of these downgrades and the future of ESG ratings. And while MSCI and others may applaud this as a positive ‘anti-greenwashing’ step, it is clear that when looking at factual ESG data, the downgraded scores are still far too positive, adding even more questions into the mix.
Bracing for downgrAAAde?
When you start with subjective ratings and sentiment, you’ll always be at the mercy of rating agencies changing their methodology. However, there was a significant skew towards positive ratings even before this latest tranche of downgrades. In fact, we can see that 70% of funds were previously rated AA or above (“ESG leaders” in MSCI’s rating system)– this is despite some of the funds actually having a negative ESG impact! Read on for some examples.
After the shake-up, 95% of the AAA funds are going to be downgraded.
The downgrade isn’t enough, however. The chart below plots the before and the aftermath of MSCI’s downgrade according to the Financial Times and Impact Cubed’s distribution of European listed ETF’s net ESG impact. Net ESG impact is an objective, empirical measurement of a fund compared to its benchmark, in basis points of tracking error.
It’s clear from this data that the downgrades, while significant, haven’t gone far enough. The distribution of scores is still too skewed towards above-average ratings.
Mapping the net ESG impact of each European fund compared to its benchmark shows that the distribution is more even. When we map it to MSCI’s 7 rating buckets, most funds actually reflect a BBB or BB rating.
Perhaps it’s time for a bit more common sense when it comes to ESG: how can the vast majority of funds – and the companies they invest in – have above-average ESG performance? Are there really so few funds that are ESG laggards?
Illusory superiority or ‘adjustment factor’?
Illusory superiority bias can lead to an overestimation of positive ESG ratings over time, as positive ratings become more and more common, making lower ratings harder and harder to give out.
This bias can also be seen in MSCI’s use of an “adjustment factor”. This factor considers a fund’s exposure to companies with improving versus worsening ESG ratings, leading to a potentially inflated score for the overall fund. Currently, around 73% of ETFs and mutual funds have a positive adjustment factor, according to MSCI.
By removing this adjustment factor, MSCI is acknowledging that the current system may have overestimated ESG ratings. This move will lead to more downgrades than upgrades, as many funds will now be rated solely on the ESG scores of their underlying holdings.
Behind the curtain
To illustrate this further, let’s look at some specific funds. The Franklin Natural Resources Fund currently has an MSCI ESG rating of AA, putting it in the leader category. However, our analysis shows that the fund has a net negative ESG impact of 339 basis points, with high carbon and waste emissions and nearly 70% of its revenues attributed to environmentally harmful business activities. It also ranks in the bottom 1% of funds for ESG impact. This makes sense given the fund’s strategy, which has a heavy focus on energy and mining companies. But it raises the question: how can a fund with such a negative ESG impact be rated AA?
Looking at our 15 factor corporate model – the fund performs worse than its benchmark on 8 of the 15 factors. Each factor can be explored and analysed using our platform. Already an Impact Cubed client? See for yourself here.
Supporting this further, we looked at the EU’s Principal Adverse Indicators (PAIs), standardized measures of fund performance required to be disclosed under the new SFDR. The Franklin fund, given its heavy industry investment strategy, underperforms its benchmark on 12 of 16 PAIs. How can a fund that is performing poorly on nearly all of its ESG factors still receive such a high rating from MSCI?
The revolution is now
At Impact Cubed, we believe that fund managers have a golden opportunity to change their outlook on ESG ratings. Instead of relying on subjective scores that are increasingly viewed with skepticism by savvy investors and regulators, asset managers now have the option to use factual, outcome-based data to quantify ESG performance. By doing so, they can avoid regulatory scrutiny and create differentiated funds their clients want.
The recent downgrades by MSCI are significant, but they haven’t gone far enough. The skew towards positive ratings persists even after the downgrades. This is an industry-wide problem because it can lead to greenwashing. At Impact Cubed, we deal with ESG facts to ensure you have the whole investment picture for you and your clients.
Tired of ratings?
Request a demo of our online analytics platform to see our data in action. You can also give us a fund ISIN for a free ESG Impact report – giving you the full picture of your ESG impact and how you rank against your peers: