What MSCI’s ESG Ratings are and are not for intro
The significance of environmental, social and governance (ESG) issues in the investment industry has exploded in recent years, as seen in the tremendous growth in assets in exchange-traded funds and other products marketed as ESG investments. This has raised a number of important definitional questions, including the definition of an ESG rating.
This post aims to clarify what an MSCI ESG rating is and is not. It is essential to have full transparency on the purpose, methodology and intended use of a rating to assess its usefulness and effectiveness. Some think MSCI ESG ratings are like credit ratings. Others think they should be focused on climate or rejuvenating the planet. Both interpretations misconstrue their true purpose.
MSCI’s ESG ratings are designed for one purpose: to measure a company’s resilience to financially material environmental, societal and governance risks. Our ESG ratings provide a window into one facet of risk to financial performance. They are not a general measure of corporate “goodness,” a barometer on any single issue or a synonym for sustainable investing.
Here are five key things to know about MSCI’s ESG ratings and what investors can learn from them.
What MSCI’s ESG Ratings are and are not for
1. Our ESG ratings are designed to look at the financial significance of ESG issues.
Institutional investors such as pension funds, sovereign wealth funds, endowments and asset managers who have a fiduciary duty to consider significant investment risks commonly use ESG ratings to assess financial risks in the investment process.
To support this investment focus, we zero in on the intersection of a company’s business and the relevant ESG issues that can create significant risks and opportunities for its industry, according to a rules-based methodology. Our searchable ESG industry materiality map shows the key issues we assess for companies across 158 industries.
For instance, to determine whether a maker of semiconductors risks running out of the water it needs to make chips, investors may consider whether the company operates in a locale that requires it to conserve water. They also might consider the prospect of regulation on water usage, potential conflicts with the community and whether management is taking steps to address those concerns.
To gauge financial risk to a commercial real estate developer, by contrast, investors might want to understand its ability to meet demand from office and retail tenants for buildings designed for indoor air quality. To assess whether a financial company risks losing out on top talent, investors might look at data on the diversity, equity and inclusion of its workforce.
As these examples demonstrate, MSCI’s ESG ratings focus on financial risks to a company’s bottom line. That is by design to help institutional investors assess such risks and to deploy capital in ways that maximize investment return over their time horizon.
Clients come to us for ESG ratings that support their investment processes and objectives. We build and enhance our ratings based on annual consultations with investors worldwide, who describe to us their need to evaluate material ESG and climate risks and opportunities, which evolve as our world changes. We also validate that our ratings capture the risks they are designed to measure, through published quantitative studies.
2. Our ratings support ESG integration. Other MSCI tools support additional approaches to ESG investing.
From serving a wide range of investors globally, we know that one size does not fit all. Each investor has its own investment objectives and ways of incorporating ESG considerations in its portfolios. MSCI provides a wide variety of analytical tools to help investors in that process based on the unique objectives they aim to achieve. We do not provide investment advice, but we do provide the transparency investors need to make better informed decisions.
Though ESG investing has been referred to in many different ways, from socially responsible investing to mission-related investing, we group the various names into three approaches that investors use to achieve distinct ESG objectives: ESG integration, impact investing and values-based investing.
Our ESG ratings are designed specifically for ESG integration, which uses ratings to support the building of a resilient portfolio for the specific purpose of enhancing long-term risk-adjusted returns. By helping institutional investors integrate ESG into their strategies, ratings have helped accelerate adoption of ESG considerations into mainstream investing.
Investors also may pursue impact investing, which targets investments that aim to generate measurable social or environmental impact. To pursue such strategies, investors can turn to tools such as our SDG Alignment Tool, which provides a holistic view of a company’s contribution to addressing each of the U.N. Sustainable Development Goals. An ESG rating would not further a strategy that puts generating impact ahead of performance.
We also offer analytical tools for investors who pursue values-based investing, which aims to align portfolios with an investor’s ethical values by expressing preferences for the industries and companies they invest in. A values-based investor might use our business-screening tools or MSCI indexes designed to avoid investments in controversial weapons or tobacco, for example. An ESG rating, by itself, would not provide a values screen.
Understanding the most common ESG objectives
While each of the three approaches serves a specific purpose, the nuances among them can get lost in the discussion about sustainable investing and the tools investors use to pursue them. Investors also may combine elements of each approach with the aim of managing long-term risk, reflecting individual values and generating positive impact.
Our clients can and do use ESG ratings alongside additional layers of ESG, impact and climate metrics to inform their decisions and pursue the objectives and outcomes they desire. Still, our ESG ratings are designed for evaluating a company’s resilience to ESG risks and to support ESG integration.
3. Our ESG ratings assess how well companies manage risk compared with their peers, not across industries.
Some investors will favor or avoid certain sectors for a variety of financially or values-driven reasons. Within a given industry, however, investors want to know how companies compare with one another based on their exposure to, and management of, financially relevant ESG risks. If the chipmaker noted above has a high exposure to the risk of water stress and manages that risk poorly compared with its industry peers, that risk will show up in its ESG rating.
Of course, different industries face different risks. Carbon emissions, for example, will affect the rating of an oil company far more than that of a restaurant company. Imagine a fast-food chain that increases emissions from one year to the next while still improving both its overall ESG rating and its environmental score. Some people might find that confusing, but it is easily explained: Other ESG factors — such as sourcing of inputs, packaging waste and product safety — are more financially relevant to the fast-food chain than the carbon emissions of its operations, and thus weigh more heavily in its ESG rating and environmental score. Also, despite increasing its emissions, the fast-food chain might still have a smaller carbon footprint compared with its industry competitors.
4. Investors use other tools to address climate risk.
ESG ratings are not climate ratings.
If a company’s greenhouse gas emissions pose significant financial risks, its ESG rating will reflect that. For example, direct emissions pose a significant risk to power and steel companies, while emissions from their products after they have left the factory gate can pose a significant risk to automobile companies. But for industries such as health care, the most financially relevant risks lie elsewhere, so emissions have less influence on a company’s rating.
If investors want to understand the carbon footprint of a health care company, they can use climate tools that measure emissions more directly. MSCI provides over 500 climate metrics as a complement to our ESG ratings.
Many institutional investors are also now working to bring their portfolios in line with net-zero climate commitments. Here they aim explicitly to reduce external impacts; namely to rein in emissions and keep global warming to 1.5°C.
For that, investors use different tools and metrics, as well as data about companies’ complete carbon footprints. Corporate reduction targets and emissions trajectories, translated into an Implied Temperature Rise, show where companies and portfolios are headed and where more aggressive action is required. Investors use still other tools to compare corporate decarbonization targets and track companies’ progress to reduce emissions.
We have called for companies, investors and other capital-markets participants to drive a net-zero economy with the urgency the challenge demands. We publish a quarterly Net-Zero Tracker that takes the temperature of listed companies in every sector, spotlights those with the most comprehensive climate targets and flags those with the largest carbon footprints. To help educate the marketplace, we make companies’ Implied Temperature Rise and ESG ratings publicly available. You can search them here.
5. Helping fiduciaries be fiduciaries also can benefit society.
The insights provided by our ESG ratings can help institutional investors pursue long-term risk-adjusted returns, which in turn provide financial security for millions of savers and retirees.
While companies manage risks and opportunities for the benefit of shareholders, doing so also can benefit communities, the environment and society. The semiconductor company that is more operationally efficient than its peers uses less water from its community. A company that is better positioned to attract top talent also expands opportunity for underrepresented demographics in the labor market.
As it happens, higher-rated companies as a group have exhibited positive characteristics across a range of measures that are important to many stakeholders, from carbon footprint to taxes paid. We do not claim that these positive outcomes are intentional. But they are nevertheless important collateral benefits generated by companies that manage their businesses with a long-term, sustainable mindset.
What MSCI’s ESG Ratings are and are not for - 2
Selected characteristics of MSCI ACWI Index constituents (average figures)
|Implied Temperature Rise (°C)||Enterprise Carbon Intensity (CO2e/EVIC)||% Female Directors||Tax Gap (percentage points)*|
|Leaders (AAA-AA) (n=634)||2.4||415.7||30.7||1.5|
|Laggards (B-CCC) (n=526)||3.0||1110.9||13.5||4.9|
*The Tax Gap reflects the difference between companies' actual tax rate and the statutory tax rate in the geographies where it operates in a five-year rolling average. A higher number represents a larger gap between what a company ostensibly owed and what it paid.
Source: MSCI ESG Research LLC. Data for constituents of the MSCI ACWI Index as of Dec. 14, 2021.
As ESG investing moves into the mainstream, we welcome the focus on sustainable finance, climate, values, impact and the conversation over approaches. We also have expressed our support for industry and regulatory developments that hold the potential to improve transparency and clarify choice for investors.
They include the emergence of a common language for ESG, as well as a variety of initiatives to set standards that help highlight methodologies and spur corporate reporting of Scope 3 emissions and other financially relevant data.
As more investors and the public confront climate change and other pressing societal challenges, they will have a lot of questions, including whether a company is climate friendly, does right by employees or cares about its community. We do not suggest that ESG ratings can answer them all. Nor should they.
Rather, ESG ratings have been and remain a tool for understanding investment risks that helps investors consider the resilience of companies and pursue their objectives over the long term.
Putting ESG Ratings in Their Rightful Place, 2022 ESG Trends to Watch, MSCI
Lee, Linda-Eling. What Does ESG Investing Really Mean? Implications for Investors of Separating Financial Materiality and Social Objectives. Wharton Pension Research Council Working Paper No. 2021-18, Oct. 5, 2021.
Lee, Linda-Eling Lee, Giese, Guido and Nagy, Zoltan. Deconstructing ESG Ratings Performance: Risk and Return for E, S and G by Time Horizon, Sector and Weighting, Journal of Portfolio Management, Vol. 47, No. 3, 2021.
Lee, Linda-Eling Lee, Giese, Guido and Nagy, Zoltan. Combining E, S, and G Scores: An Exploration of Alternative Weighting Schemes. The Journal of Impact & ESG Investing, Vol. 1, Issue 1, 2020.