By Greg Losch
As ESG investing as a practice has continued to grow in popularity over the past decade, many investors with noble intentions have been misled concerning how companies are deemed ESG-compliant. The main culprit behind this scheme? Rating agencies, and there’s none more prominent in the ESG space than MSCI. A once unnotable New York-based rating agency, MSCI rebranded itself in 2019 once it recognized ESG as the future of the financial services industry and subsequently established its ESG rating index.
ESG rating agencies like MSCI assist companies and hedge funds eager to capitalize on the trend of socially-conscious investing by seeking the highly-illustrious “sustainable” label on their stocks. These agencies supposedly evaluate each corporation’s ESG practices, and from that, they produce ratings to indicate to investors how seriously each company treats ESG risks. Investors can then turn to any Wall Street hedge fund that offers an ESG Fund comprised of companies that have received a high ESG rating. Everybody wins, right?
The problem arises once it is understood that this essential practice of ESG rating occurs in an unregulated, unchecked environment. MSCI’s CEO Henry Fernandez has publicly defended the agency’s credibility, citing a company mission intent on helping “global investors build better portfolios for a better world.” In reality, MSCI’s methodology differs from its message.
Rather than measuring a company’s impact on the environment and society, MSCI’s ESG index measures potential risks that environmental and social factors may have on the business and its returns. Under the guise of quantifying social responsibility, MSCI is measuring financial risks. MSCI is effectively confounding social responsibility with financial liability when, more often than not, these two things are directly and wholly opposed to one another. While MSCI openly defends their methodology as the most financially relevant indicator, misuse of the “sustainable” label on stocks continues to dupe unsuspecting individuals intent on investing in socially and environmentally responsible companies.
The leniency of MSCI’s rating system makes it increasingly easy for companies with expansive ESG-related issues to market themselves as socially responsible publicly. A recent analysis by Bloomberg noted that out of the 155 companies with increased ESG ratings, only one received an upgrade for cutting emissions. Meanwhile, Big Tech companies such as Meta have received high ratings from MSCI and are subsequently listed on numerous ESG funds despite being the recipients of public outcry concerning the misinformation and hate speech allowed on their platforms. Similarly, MSCI has granted companies in sectors whose operations are inherently opposed to ESG practices, such as BP and Exxon, relatively high ratings.
Just as cynicism and mistrust related to the viability of ESG have grown as a result, the Securities and Exchange Commission has acknowledged the need for sweeping and expansive regulation. The SEC has recently proposed new regulatory measures to upend this scheme and redefine how rating agencies understand and measure ESG indicators. Specifically, the new rule would enforce consistency between rating agencies and require ESG disclosures to include the indicators considered when assigning a rating. As expected, this announcement was met with fierce resistance from rating agencies. Not only did MSCI claim regulation was unnecessary, but it also argued that measures to standardize ESG scores could lower the quality of ratings and harm the market. Concurrently, hedge funds that have benefitted from MSCI’s lax rating process are speaking out against SEC regulation out of fear that stricter ratings could mean investors will pull cash from funds that are set to lose the highly-coveted ESG status.
European regulators have discussed similar regulations and believe the next natural step is to create a singular rulebook covering ESG ratings and forcing rating agencies to release relevant information regarding their scoring criteria. While it remains to be seen whether these SEC regulations are enacted effectively and holistically, the mere recognition of the ESG rating problem indicates progress.