ESG-Ratings (Environmental, Social, Governance). Standards, challenges and solutions

Table of content

Table of content

List of figures

List of tables

1 Introduction

2 Term discussion SRI and ESG
2.1 SRI - Socially Responsibility Investment
2.2 ESG - Environment, Social and Governance Investing

3 Ratings - Standards
3.1 Types of ratings
3.2 Rating Agencies
3.3 Challenges of ratings
3.3.1 Structured products
3.3.2 Compensation of rating agencies

4 Ratings in ESG
4.1 Difference between credit ratings and ESG ratings
4.2 Approaches of rating agencies
4.3 Regulation of ESG
4.4 Challenges of ESG ratings
4.4.1 Different approaches
4.4.2 Transparency
4.4.3 Bias and reliability
4.4.4 Lack of independence
4.4.5 Greenwashing

5 Outline of the challenges
5.1 Course of action
5.2 Chosen industries
5.3 Controversy in the fashion industry
5.4 Controversy in the automobile industry

6 Evaluation and debate on solutions
6.1 Stricter regulations
6.2 Building a metrics
6.3 Determine own standards

7 Recommendation for action and conclusion

Appendix

The Appendix has been removed by GRIN for copyright reasons

Bibliography

Internet sources

List of figures

Figure 1 - 5 have been removed by GRIN for copyright reasons

Figure 1: ESG Factors - This figure has been removed by GRIN for copyright reasons

Figure 2: ESG Ratings

Figure 3: MSCI ESG rating scale

Figure 4: Risk categories

Figure 5: ISS Rating scale

Figure 6: Reuters weighting

List of tables

Table 1: Rating scales

List of abbreviations

ABS Asset-backed securities

AML Anti-money laundering

CSR Corporate social responsibility

CTF Counter-terrorist financing

EBA European Banking Authority

ECB European Central Bank

ESG Environment, Social and Governance

ESGC Environment, Social and Governance controversies

ETF Exchange-traded funds

EV Electric vehicle

ISS Institutional Shareholder Service

NGO Non-governmental organisation

S&P Standard & Poor's

SFDR Sustainable finance disclosure regulation

SPV Special purpose vehicle

SRI Social responsibility investments

1 Introduction

Sustainability has been a highly debated topic for a long time. Waste separation, the purchase of regional food, electricity supply options and the fight against plastic waste are indispensable topics for society. The matter has not yet played such a significant role in financial investments, but interest is growing. Millennials are open to sustainable investments. This area of interest is shown by a representative YouGov study commissioned by the fund company Deka. Nevertheless, only six per cent of investors own sustainable investments.¹ This occurrence is maybe because the topic is complex for investors to grasp. There is even a lack of a generally valid definition of sustainability. There are indeed several quality seals that make orientation easier, but there are no standards. The EU Commission wants to change that and is working on critical criteria for sustainable investments, but it will be some time before these are fully implemented throughout the EU.²

However, there are approaches to combine traditional investments and insights from the environment, social and corporate governance (ESG). They provide orientation, enabling both global institutional investors and private individuals to pursue their investment goals in a sustainable manner. These are Ratings that are specifically designed for these ESG factors that can help with investment decisions.³

ESG ratings are not only beneficial for investors but also for the company itself. Positive sustainability performance increases long-term shareholder value and provides inspiration for business improvement. Many large companies even make their executives' compensation partly dependent on the achievement of ESG goals. In addition, large companies are investing increasing amounts in corporate social responsibility (CSR), green projects, and transparency disclosure.⁴

However, as much as there seems to be agreement on the high relevance of sustainability, there is little agreement on the answer to the question of how a company's sustainability performance can be measured at all. Various rating agencies offer assistance to interested stakeholders. Undoubtedly, such ratings often provide valuable indications and food for thought. However, due to the lack of a common understanding of the term sustainability, it is not clear what such ESG ratings measure at all.⁵ According to a 2020 BlackRock survey of 425 investors worldwide with a combined $25 billion in assets under management, low-quality or unavailable ESG data and analysis most significant barrier to sustainable investing.⁶

In addition, the quality of ESG ratings suffers because there are no generally applicable laws or regulations on how to assess a company's sustainability. On the one hand, rating agencies should develop their own subjective, universal rating methodology; on the other hand, all companies are very individual, so it is almost impossible to create a universal approach.⁷

This bachelor thesis examines the challenges of ESG ratings and attempts to find a solution to these explored challenges. To answer this question, a theoretical definition of ESG and SRI is given first, followed by a discussion of ratings' theoretical background, standards, and rating agencies' traditional procedures. The classic challenges of ratings are also considered. The differences to ESG ratings are then discussed, and sustainability ratings and sustainability rating agencies are examined. In the following part, the individual challenges of ESG ratings discussed theoretically are described. After the theoretical foundations, the challenges are clarified in an analysis. The analysis refers to two different industries. Based on the results, possible solutions are proposed and discussed. A conclusion is followed.

2 Term discussion SRI and ESG

2.1 SRI - Socially Responsibility Investment

The usage of corporate responsibility for environmental and social issues is not only demanded by society and the government, but companies themselves are also increasingly showing interest in addressing these aspects. The drivers for this are probably less an essential philanthropic attitude than the intention to prevent damage to reputation or to meet the growing customer awareness for sustainable products and responsibly acting companies. Current environmental challenges, such as the overexploitation of resources, climate change or rising energy demand, offer economic opportunities but also entail risks.⁸ Rising negative externalities inevitably translate into higher costs for the company in terms of higher insurance premiums, prices, and taxes, which does not affect the profitability of globally invested portfolios. From this perspective, environmental and social aspects are becoming more attractive for investors and an inevitable part of investment considerations. Therefore, more investors are taking sustainable, social and environmental criteria into account in their investment strategies, making so-called socially responsible investments (SRI).⁹

The term Socially Responsible Investment is used differently by various actors in different countries. For example, the term sometimes refers to investment activities that take exclusively social standards into account in addition to economic criteria. Still, sometimes it also refers to activities that take environmental criteria or criteria for good corporate governance into account. It is also expressed in the increasingly widespread reinterpretation of SRI's abbreviation from Socially Responsible Investing to Sustainable and Responsible Investing.¹⁰

Socially Responsible Investment differs from similarly oriented, increasingly popular concepts such as Impact Investing or ESG Investing. ESG Investing primarily focuses on so-called negative criteria used to exclude industries and companies that are classified as contrary to socially and/or ecologically sustainable development, e.g., nuclear power, child labour, armaments. Unlike Impact Investing or ESG Investing, socially responsible investing is based on ethical guidelines to identify and promote industries and companies that are classified as conducive to socially and/or environmentally sustainable development, e.g., organic farming, natural medicine, renewable energy. In this respect, Socially Responsible Investment seeks to prevent negative social and/or environmental impacts of its investments. In Impact Investing and ESG Investing, on the other hand, the focus is more on promoting positive social and/or ecological developments.¹¹

SRI, ethical and sustainable investments or other investment strategies associated with the terms ethical, sustainable, responsible or social, embody an investment approach that focuses on socially and environmentally responsible companies. The term most used in the literature is SRI and refers to investments that consider so-called ESG criteria, i.e., environmental, social and governance criteria. ESG thus refers to a concept that informs investors about the risks and opportunities of companies based on additional non­financial information and therefore serves as a decision-making aid.¹²

2.2 ESG - Environment, Social and Governance Investing

ESG is becoming increasingly crucial for both institutional and private investors. The practice of ESG investing began in the 1960s as socially responsible investing, where investors excluded stocks or entire industries from their portfolios because of business activities such as tobacco production or involvement in the South African apartheid regime. Today, ethical considerations and value alignment remain common motivations for many ESG investors. Still, the field is rapidly growing and evolving as many investors seek to incorporate ESG factors into the investment process alongside traditional financial analysis.¹³ To date, there is no uniform, generally accepted definition of the ESG concept in the sense of a set of environmental, social, and corporate governance criteria. However, there are initial efforts on investors to establish a common understanding of ESG at the international level.¹⁴

The abbreviation ESG has become established when talking about sustainability in general or climate change in particular. The term indicates whether attention is paid to socially responsible aspects and ecological approaches in the management of a company or even in corporate decisions. The principle of sustainable resource management means that no more may be consumed than can grow back, regenerate or be made available again in the future. The term has also become established internationally in the financial world to describe how, for example, ecological and social aspects, as well as the type of corporate governance, are taken into account and evaluated by financial service providers or issuers. On the other hand, sustainable investment is about how decisions can be meaningfully drawn from these three areas to contribute to sustainability in the world ultimately.¹⁵

Figure 1

https://www.cfainstitute.org/en/research/esg-investing

This figure has been removed by GRIN for copyright reasons.

As seen in the figure above, ESG criteria are mainly divided into three groups. The environmental criteria are assessment points related to climate, resource scarcity, water, biodiversity, energy, and everything related to environmental pollution. The social criteria relate to employees' protection and engagement, health and safety, demographic change and food security. Governmental measures examine risk and reputation management, supervisory structures, compliance, and corruption in the company. However, the criteria are not fixed, and there is no regulation as to which elements must be included in the individual pillars. These, therefore, vary from company to company¹⁶ ESG criteria are used by conscious investors and shareholders to screen investments and assess a company's impact on the world. The criteria influence how a company receives and retains money from investment funds that follow a socially responsible investment strategy. ESG can also refer to ESG reporting, especially the data disclosed concerning ESG criteria, e.g., greenhouse gas emissions. ESG performance refers mainly to how companies perform in ESG areas and an ESG score or rating, which determines an assessment of ESG performance by a third-party organisation.¹⁷

The reasons for sustainable investments in investment management are manifold. Due to the Paris Climate Agreement adopted in 2015 and the sustainable development goals set by the UN, the topic of sustainable development has gained importance in society. Municipalities can contribute to the achievement of these goals through sustainable investments. In addition, the use of sustainable investment criteria can also serve as an additional risk filter, so that bad investments in sectors that are losing importance due to regulatory developments or climate damage can be avoided.¹⁸

The ESG criteria play a decisive role in the composition of a sustainable investment portfolio or selecting sustainable investments. Investors can directly exclude companies or entire sectors as investments (negative criteria) or define criteria that must be met to consider an investment (positive criteria). As an example of a negative criterion, an investment in companies involved in the production or trade of weapons could be excluded. Investors could also specify that they only invest in bonds issued by companies whose sustainability rating is among the 50 per cent best in the respective sector. The latter would be an example of a positive criterion combined with the best-in-class principle. Here, the investor sets standards that must be met for companies to be considered as potential investments. The best-in-class principle restricts the possible companies that have performed exceptionally well in the sector in terms of the criteria.¹⁹

3 Ratings - Standards

3.1 Types of ratings

A distinction must be made in the rating according to who prepares the rating. If a private, independent provider, e.g., Standard & Poor's, is commissioned with the rating, it is an external rating. This rating can not only be used as a basis for creditworthiness checks with banks, but it is also used, for example, in negotiations with investors or the issuance of corporate bonds. Other target groups can also be other stakeholders such as suppliers or employees. On the other hand, the internal rating is prepared by the bank granting the loan. The objective here is to provide a credit rating for the company to be rated. In contrast to external ratings, these ratings are not published. In the case of external ratings, the publication is voluntary. Furthermore, a distinction is made between emission and issuer ratings. Within the framework of an issuer rating, an assessment is made of a single financial instrument, for example, a corporate bond. If a company has issued several corporate bonds, different ratings may result due to different collateralisation. On the other hand, an issuer rating assesses a company's fundamental creditworthiness and solvency unrelated to individual financial securities. Regarding the client of a rating, a distinction is made between solicited and unsolicited ratings. If the rating is commissioned by the company to be rated itself, it is referred to as a demanded rating. If third parties, e.g., interested investors or the rating agency, carry out a rating on their behalf, this is called an unsolicited rating. In this case, the rating can usually only be based on publicly available information. The informative value of the rating can suffer as a result. Another type of rating, an industry rating, is when an entire industry is rated rather than an individual company.²⁰

3.2 Rating Agencies

Rating agencies use essentially the same procedures that corporate analysts use. While equity analysts take the perspective of shareholders, those who have claims on the residual income, rating agencies take the perspective of creditors.²¹

Rating agencies are not very transparent about their procedures, although openness has increased significantly over the years - after Enron in 2001 and Lehman in 2008 - due to regulation and thus also due to the crisis. Companies are assessed in the light of business risks, sector characteristics, competitive position, management quality, financial data, profit perspectives and equity. To determine financial strength, the agencies identify various indicators, e.g., debt coverage, leverage, or cash flow, which they track over time and individual companies. At the same time, the agencies point out that the qualitative, analytical interpretation of these quantitative indicators is crucial. Thus, according to the agencies, the indicators alone are not sufficient to derive the judgement expressed in the rating scales. They built expert systems whose verdicts cannot be directly replicated. The agencies are concerned with an assessment of the borrower in the medium term. It is also intended to ensure the stability of the evaluation. It is associated with a slow, hesitant adjustment of the assessments to changing conditions. In the current review, the agencies inevitably lag behind the market assessments, as expressed above all in interest rate premiums and premiums for credit default swaps.²²

Three agencies have practically divided up the market in a tight oligopoly since the beginning of credit rating. These are Moody's, Standard and Poors (S&P) and Fitch Ratings. The institutes follow different approaches to rank the quality of promises to pay on a scale, as seen in the table below.²³

Table 1: Rating scales

Abbildung in dieser Leseprobe nicht enthalten

Source: https://corporatefinanceinstitute.com/resources/knowledge/credit/fitch- ratings/ , Access 18.06.2021; https://www.thebalance.com/what-are-sandp-credit- ratings-and-scales-3305886, 18.06.2021; Moody's Corporation, Rating, 2021, p. 9 ff.

On average, in the past quarter-century, the agencies have met expectations about the alternatives, which promise similar performance. Banks have been using internal models and institutional investors such as insurance companies, fund management companies, etc., which have specialised analysis departments or independent analysts. The interaction of all these actors results in prices or interest rates on the market. Their differences, in turn, also convey the assessment of the respective creditworthiness, which is determined by buying and holding. However, it should be said that there were also wrong decisions despite a wide range of models and calculations.²⁴

3.3 Challenges of ratings

3.3.1 Structured products

Rating agencies made the most severe misjudgements when assessing securitised receivables - asset-backed securities (ABS) - that were booked on the assets side of so- called special purpose vehicles (SPV). The business purpose of these companies was to buy loans granted by credit institutions. The model, originate to distribute or credit origination and on-lending, was designed to relieve the banks' equity. The SPVs as independent business units remained below the balance sheet line. Therefore, the lending banks only had to hold equity against the loans created on their balance sheet. The scarce equity could therefore be used revolvingly to create credit. In addition, the special purpose vehicles were liable, whereas the banks, which had originally issued the loans, no longer had any obligation for their recoverability. From the banks' point of view, the special purpose vehicles were bankruptcy remote. The companies securitised the interest and redemption payments of the receivables assigned to them. The securities were built in this way were thus secured by a bundle of receivables. The decisive factor for the acceptance of these securities was their rating-by-rating agencies. Their exceptionally high ratings, more than two-thirds in the highest, i.e., AAA category, were decisive for the fact that such products met with such great investor interest among institutional investors, but also banks. It proves that structured products themselves are difficult for rating agencies to see through and thus offer a challenge.²⁵

3.3.2 Compensation of rating agencies

One cause for misjudgements is often seen in the way rating agencies are reimbursed. Banks pay for their rating. At the very least, this fosters incentives for collusive behaviour. There are apparent conflicts of interest. In 2012, this was empirically examined using the example of the change in S&P's payment model. According to this, the issuer-pay remuneration model introduced by S&P led to an increase in credit ratings and decreased rating downgrades. A threatened downgrade could induce a borrower to switch rating agencies. It would make a loss of revenue inevitable in an environment where the choice of agency is optional. However, this problem is mitigated with the number of clients and the consequently reduced dependence on particular borrowers. Conversely, it is equally valid that as the issuers' power of influence increases, the agencies' reliance increases implicitly. At the same time, there was an incentive to accommodate the clients. After all, the reputation of a rating agency depends on its market share, which at the same time signals expertise. The market share, in turn, grows with the reputation. The latter is equivalent to cash in on reputation acquired over time. This conflict of interest is also severe because ratings usually represent lasting relationships, and therefore the loss of fees is a lasting one. However, the fact that agencies are dependent on their reputation capital speaks against the imputed venality of agency judgements.²⁶

4 Ratings in ESG

ESG ratings are in vogue. On the one hand, it is due to increasing regulatory pressure, and on the other hand, the market for green finance offers new opportunities to use these sustainability ratings. As a result, more and more financial managers are taking a closer look at this rating class. No key financial figures are included in this rating. Instead, a whole range of other criteria is examined, which can differ significantly depending on who prepares the rating. After all, there is no uniform definition of sustainability. While specific factors assessed vary from company to company, ESG rating firms typically review things like annual reports, corporate sustainability measures, resources, employee and financial management, board structure and compensation, and even controversial weapons investigations.²⁷

The company carbonclick, which helps customers offset their carbon emissions while making a purchase and in financial decisions, has highlighted the average breakdown of an ESG rating in the chart below. First, the issue score is considered. These are individual issues important to the respective company and its shareholders, such as climate change, labour standards or shareholder rights. These indicators are given a weighting and a key score. For example, for the theme score climate change, the emissions per year are used. Then these cumulative scores are added together to form the pillar score - Social, Governance and Environment. These three-pillar scores are then used to calculate a cumulating total ESG performance.²⁸

Figure 2: ESG Ratings

https://medium.com/carbonclick/what-is-esg-and-why-is-it-important-f9036bb96d66

This figure has been removed by GRIN for copyright reasons.

The rating evaluates sustainable investments and companies and focuses on what matters to a company's bottom line and is comparable to its peer group. While traditional investments are reviewed according to the economic criteria of profitability, liquidity and risk, sustainable investments are evaluated according to their fulfilment of ESG criteria. The ratings provide information on how sustainable an issuer, e.g., company or financial product, exchange-traded funds (ETF), is or to what extent the ESG criteria are implemented within a company. Based on the ESG rating, investors can thus determine whether a potential investment meets their requirements for sustainable investment management.²⁹

4.1 Difference between credit ratings and ESG ratings

Ratings serve to eliminate information asymmetries between stakeholders and companies. In order to achieve this, the information provided must be useful for decision­making. It is achieved when the addressee reinforces or corrects a company in its assessment. In financial ratings, this information is used to assess whether companies will meet their payment obligations on time in the future. It can be measured by the current debt situation and the predicted financial strength in the future. Based on this approach, various ratios have become established. These include, for example, the equity ratio or the ratio of operating cash flow to interest-bearing debt. These represent a correlation to creditworthiness. Financial ratings, therefore, have a clearly defined objective and an established form of operationalisation.³⁰

Consequently, in finance, a rating is the classification of the creditworthiness of an issuer, e.g., a company or a financial product. The rating thus assesses the probability of an issuer being able to meet its payment obligations. On the one hand, the rating is of particular importance for banks, as they assess the borrower's creditworthiness for the purpose of granting loans, which is included in the loan conditions, among other things. On the other hand, the rating is particularly important for investor groups that are obliged either by law, pension funds, by their investment guidelines or municipalities, to invest in particularly safe investments or investments with an excellent credit rating.³¹ A distinction is made between internal and external ratings, as explained in chapter 3.

Credit ratings are meant to measure the relative probability of the fault of a bond issue or an issuer and their opinions, their mix of quantitative in a judgment. ESG ratings, in fact, measure how that issuer performs and what an issuer does, wheatear it is an equity or bond issuer. There are more quantitatively oriented assessments and they are not regulated products. They are distinct products, and these are complementary investors who use both when they do an ESG analysis and credit risk analysis.³²

In summary, ESG ratings take up the evaluation of sustainable investments or also companies. While traditional investments are evaluated according to the economic criteria of profitability, liquidity and risk, sustainable investments are evaluated according to their fulfilment of ESG criteria. The ESG rating provides information on how sustainable an issuer, e.g., company or financial product, an ETF is, or to what extent the ESG criteria are implemented within a company. Based on the ESG rating, investors can thus determine whether a potential investment meets their own requirements for sustainable investment management. The increased interest in sustainable investments has also led to more companies specialising in ESG ratings establishing themselves on the market.³³

4.2 Approaches of rating agencies

There are now many rating agencies that specialise in rating companies according to ESG criteria. Each agency has its measurement methods, processes, or weightings.³⁴ In the following, ESG ratings are analysed and compared.

MSCI ESG Research is a rating agency headquartered in New York that is the world's largest provider in this field, with over 1,500 different ESG indices and 130 analysts. Accordingly, MSCI ESG Research enjoys a high reputation in the industry. MSCI ESG Research is fully integrated into the MSCI Group, which employs 3,000 people.³⁵

MSCI ESG Research examines 37 key ESG themes, divided into the three main pillars and ten topics, which are climate change, natural resources, pollution and waste, environmental opportunities, human capital, product liability, stakeholder resistance, social opportunities, corporate governance and corporate behaviour.³⁶

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¹ See, https://www.springerprofessional.de/wertpapiergeschaeft/aktie/auf-der-suche-nach-neuen- geldanlagen/6605710, Access, 01.08.2021.

² See, Pavoni, S., Meaning of Green, 2021, p. 5.

³ See, Boffo, R., Patalano, R., ESG Investing, 2020, p. 14 f.

⁴ See, Kopp, H., CSR und Finanzratings, 2016, p. 195 ff.

⁵ See, https://www.flossbachvonstorch-researchinstitute.com/de/studien/nachhaltig-janeinvielleicht-zur- mangelnden-vergleichbarkeit-von-esg-ratings/, Access 14.06.2021.

⁶ See, https://www.blackrock.com/corporate/about-us/blackrock-sustainability-survey, Access 01.08.2021.

⁷ See, https://hbr.org/2019/05/the-investor-revolution, Access 21.06.2021.

⁸ See, Aguilera, R., Dorobantu, S., Luo, J., Milliken, F., Stakeholder Governance, 2018, p. 1 ff.

⁹ See, Schneider, A., Schmidpeter, R., Corporate Social Responsibility, 2015, p. 1023.

¹⁰ See, Schneider, A., Schmidpeter, R., Corporate Social Responsibility, 2015, p. 1024.

¹¹ See, Schneider, A., Schmidpeter, R., Corporate Social Responsibility, 2015, p. 102 ff.

¹² See, Everling, O., Social Credit Rating, 2020, p. 370 ff.

¹³ See, https://www.msci.com/our-solutions/esg-investing/what-is-esg, Access 21.06.2021.

¹⁴ See, Everling, O., Social Credit Rating, 2020, p. 370 ff.

¹⁵ See, DWS, ESG Handbuch, 2019, p. 8.

¹⁶ See, https://www.cfainstitute.org/en/research/esg-investing, Access 11.06.2021.

¹⁷ See, https://www.forbes.com/advisor/investing/esg-investing/, Access 21.06.2021.

¹⁸ See, PRI Association, UN-Goals for Investors, 2016, p. 6.

¹⁹ See, https://www.msci.com/esg-101-what-is-esg, Access 18.07.2021.

²⁰ See, Pape, U., Finanzierung und Investition, 2018, p. 272 ff.

²¹ See, https://corporatefinanceinstitute.com/resources/knowledge/finance/rating-agency/, Access 18.06.2021.

²² See, Moody's Corporation, Rating, 2021, p. 9 ff.

²³ See, https://corporatefinanceinstitute.com/resources/knowledge/finance/rating-agency/, Access 18.06.2021.

²⁴ See, Everling, O., Diab, Z., Rating, 2016, p. 56 ff.

²⁵ See, Everling, O., Diab, Z., Rating, 2016, p. 68 ff.

²⁶ See, Everling, O., Diab, Z., Rating, 2016, p. 68 ff.

²⁷ See, https://www.msci.com/our-solutions/esg-investing/esg-ratings, Access 21.06.2021.

²⁸ See, https://www.carbonclick.com/how-it-works/, Access 21.06.2021.

²⁹ See, Boffo, R., Patalano, R., ESG Investing, 2020, p. 3.

³⁰ See, https://www.fitchratings.com/products/rating-definitions, Access 21.06.2021.

³¹ See, https://corporatefinanceinstitute.com/resources/knowledge/finance/rating-agency/, Access 21.06.2021.

³² See, https://www.unpri.org/credit-risk-and-ratings/understanding-credit-ratings-and-esg- factors/85.article, Access 21.06.2021.

³³ See, https://hbr.org/2019/05/the-investor-revolution, Access 21.06.2021.

³⁴ See, https://corpgov.law.harvard.edu/2017/07/27/esg-reports-and-ratings-what-they-are-why-they- matter/, Access 28.07.2021.

³⁵ See, https://www.msci.com/our-solutions/esg-investing/esg-indexes, Access, 03.07.2021.

³⁶ See, Moody's Corporation, Rating, 2021, p. 12 ff.