Some 31,000 funds are about to have their ESG scores lowered at MSCI Inc., as the firm’s ratings unit works through a major overhaul of its methodology in response to feedback from market participants.
Clients had voiced concerns about “an upward drift in ratings across the fund universe,” which is now being addressed, according to MSCI ESG Research. The changes mean that only 0.2% of funds will have a AAA rating in the future, compared with roughly 20% now, according to MSCI estimates.
The measures include giving managers of swap-based exchange-traded funds six months to provide data on their underlying index constituents, which MSCI will start using to generate environmental, social and governance scores instead of collateral, it said.
The new methodology, which takes effect at the end of next month, comes as ESG score providers continue to draw criticism for using inconsistent approaches that have yet to be properly regulated. That’s made a crackdown on ESG ratings a priority for policymakers across jurisdictions. The European Commission said last week it’s planning to unveil new industry rules in the first half of this year. And the UK has just launched a consultation on the extent to which ESG raters need to be reined in by clear rules.
MSCI said its changes aren’t “linked to regulatory developments in the EU or elsewhere.” Instead, the company said the “methodology changes were driven by consultations with clients” and “based on market feedback.”
Given the pressure to improve ESG analysis, MSCI said it now believes that the threshold required to receive a top rating of AA or AAA “should be more rigorous and ambitious.”
Institutional investors have already started weighing in.
“Any significant adjustment to a rating is likely to lead to investors re-examining their portfolio to establish whether the fund continues to deliver in line with their strategy and investment beliefs,” said Joe Dabrowski, deputy director of policy at the UK Pensions and Lifetime Savings Association, whose members oversee a combined £1.3 trillion ($1.6 trillion).
Unreliable ESG ratings are “an industry-wide problem” that can “lead to greenwashing,” Impact Cubed, an ESG data provider, said in a statement. It’s found examples of funds that carry either AA or AAA ESG ratings at MSCI while having almost 70% of revenues derived from environmentally harmful activities, or by just tracking a broad market benchmark. The absence of a uniform approach in the ESG ratings industry “is unhelpful to end-investors,” Dabrowski said.
Europe’s Platform on Sustainable Finance, which advises the EU Commission on ESG investing, intends to provide recommendations to ESG data providers and ratings companies on taxonomy-related products and services, especially on estimates, and that includes on ESG indexes, Helena Vines Fiestas, the group’s chair, told Bloomberg.
MSCI said its new methodology means it will include about 8,200 new fixed-income funds in its coverage universe, “along with their numerous share classes.”
After the changes have been pushed through, MSCI expects not only that its universe of AAA-rated funds will almost disappear, but that the proportion of BBB-rated funds will rise to roughly 26% from 21%. Some 44% of funds will carry an A rating, compared with just over 17% currently, it said. There will be a little over 22% of funds rated AA, compared with almost 33% today.
The changes will reflect a simpler methodology, whereby ESG quality scores will be based solely on the weighted average ESG score of the underlying fund holdings, according to MSCI. Previously, the company had included an additional layer in its analysis, which it called an adjustment factor. The variable looked at the exposure to holdings with ESG ratings changes, as well as the exposure to holdings with B or CCC scores.
“Institutional investors that have a fiduciary duty to consider significant investment risks now often analyze the ESG characteristics of their funds’ investment profiles,” MSCI said. “Assessments of funds’ ESG characteristics can be an important input to the fund selection process, but to be useful for decision-making, assessments need to provide meaningful differentiation and a meaningful reflection of funds’ ESG exposures.”
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