ESG funds have been under scrutiny lately with allegations of greenwashing and calls to reform the entire system. Part of the problem is a lack of regulation around ESG ratings. Many investors think a fund with a high ESG rating must have high impact—after all, it did get a good rating. However, these ratings aren’t all they are cracked up to be.

Ideally investors could select from a range of ratings providers, openly publishing their standards to find those that align with their values. But that’s almost impossible to do when these institutions don’t make their scoring guidelines public.

In the graph below, you’ll see the spread of ESG scores from 5 different rating providers and the spread of credit scores from 3 major institutions. For the ESG scores the same companies have very different ratings but the credit ratings are very close, if not the same.

Why is there such a discrepancy in ESG ratings versus credit ratings?

Credit ratings apply a standardized formula to determine a company’s creditworthiness, while this may have variance from each ratings institution, they are all closely in agreement on the major factors—which you can see from the spreads below. However, ESG rating methods are not standardized or regulated—a key flaw with the current system. So, you end up with huge inconsistencies between ratings providers for the same company—notice the much larger spreads in the graph below.

Will Collins-Dean, “Do ESG Ratings Get High Marks?” Dimensional, October 26, 2021

In some cases, these discrepancies are explained by one factor: whether the ratings organization sees the company as a leader in ESG investing or a laggard. For example, let’s look at NextEra Energy, a leader in that they are a large investor and innovator in American renewable energy. But looking at the scores above, only 2 institutions consider them a leader in ESG investing and 3 place them in the average category. Why? Because the ratings agencies’ values are misaligned with those of values-based investors.

Henry Fernandez, chairman and CEO of MSCI—one of the largest ESG ratings providers—said that he knows ordinary investors have no clue how MSCI’s ESG scoring works. Bloomberg Businessweek dug deeper into MSCI’s ratings, finding that their evaluation method didn’t actually look at a company’s impact on the world surrounding them, but rather, the score is reflective of the impact the community has on its shareholders. For example, one of the cases looked at water stress and found that the score was determined by how much water the community could make available to a company’s operations, rather than how much water the company was using. Bloomberg also found that many rate increases in the governance pillar were given simply by implementing policies banning already illegal actions like money laundering. This resulted in 90% of the businesses in the S&P 500 being included in ESG funds.

Some of MSCI’s largest clients are the financial institutions producing the ESG funds that MSCI then scores. You can do the math here; is a ratings system that’s ambiguous to investors and profits from the funds it scores going to provide objective information?

Impact investing is not easy to do well, in part because of a lack of regulation and transparency around ESG funds makes it harder to align your portfolio with your values. That’s why many prefer a customized strategy, which is what we provide at Camelotta Advisors. We help clients identify the kind of impact portfolio they want the participate in, the issues they want to support and create a customized strategy to fit their needs and goals.

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