MSCI MSCI Inc

By Kristin Broughton 

Investors have become choosier about their portfolios, increasingly flocking to companies that align with their values related to the environment or social issues.

But that raises a difficult question: How can investors identify those companies?

Fortunately, they have more tools than ever to judge companies based on their values. Unfortunately, there are so many tools that they may be obscuring, instead of illuminating, the path to righteous investing.

ESG ratings firms, such as MSCI Inc. and Sustainalytics, have long scored companies on emissions, labor policies and other nonfinancial factors. Equity analysts and, in recent months, credit-rating firms have also ramped up efforts to flag potentially material environmental, social and governance risks for investors -- aspects of products or operations that could leave companies open to regulatory fines or damage to their reputations.

The flurry of firms attempting to grade companies on ESG factors, and the dizzying array of techniques and methodologies used to arrive at those scores, has led to mixed signals in the marketplace.

"Imagine if the major ratings agencies for a corporate bond disagreed, and one said a bond was investment grade and another said it was high yield," says Will Kinlaw, head of State Street Associates, the research and advisory unit of State Street Corp. "That's where we are with ESG today. It is very hard to navigate."

A multitude of recipes

ESG-scoring firms often rely heavily on information that companies voluntarily disclose in annual sustainability reports, which can be inconsistent across sectors or even within a single company year to year. Scoring firms try to find uniformity across industries by supplementing company reports with information gleaned from analysts' own surveys, interviews or online sources. From there analysts apply varying weight to factors they think are most relevant to a given industry. Each firm has its own formula, its own process.

The result: a lot of different results.

There are at least 200 providers of ESG ratings, ranging from large data providers to smaller nonprofits that focus on niche topics, such as gender pay equity, according to experts who track ESG data.

The biggest players in the market have gained influence through consolidation. MSCI has scooped up smaller competitors over the past decade, including RiskMetrics and GMI Ratings. In April, Moody's Corp. acquired a majority stake in French ESG data company Vigeo Eiris.

S&P Global Inc., meanwhile, launched an ESG evaluation tool in April, and State Street announced a partnership with Harvard Business School professor George Serafeim to help clients measure and integrate ESG performance metrics into their portfolios.

Company efforts

The increasing focus on ESG ratings, and investors' interest in sustainable finance, also has caused companies themselves to become more rigorous in how they track and report progress on ESG metrics. But here, too, the wide diversity of methods for measuring ESG performance has in some cases led to confusion -- a disconnect between the way companies view their own behavior and the scores they are given by others.

Take L'Oréal SA, which has invested in its corporate-ethics division since the appointment of its first chief ethics officer in 2007. The Paris-based cosmetics company tracks its ESG scores from several major providers, and often agrees when analysts say the company comes up short at times, says Emmanuel Lulin, the company's chief ethics officer.

But, Mr. Lulin says, the assessments overlook important elements of a company's workplace environment that can be difficult to ascertain from the outside, such as whether employees are encouraged to speak up about harassment or other potential misbehavior.

"It's really a work in progress. I think there is not enough focus on the culture," he says, discussing the ESG-scoring business. "It's more difficult to do, because it means more investment in getting to know the company and getting to know the people."

Investors have looked to regulators and standard-setters to address inconsistencies in how companies disclose ESG data. A requirement that large companies in the European Union disclose information on social and environmental issues took effect with their 2018 annual reports. And academics and investors last year asked the U.S. Securities and Exchange Commission to develop a framework for ESG disclosures.

Industry groups such as the Sustainability Accounting Standards Board, meanwhile, have established accounting methods for companies to follow in crafting their sustainability reports.

"There are so many players working on so many different levers to try to get some sort of mandatory disclosure in this space," says Louis Coppola, co-founder and executive vice president of the Governance and Accountability Institute, a sustainability consulting firm. "It is something that is needed if we want real standardized information across the board from every company, and not just cherry-picking."

Making it work

In the end, though, despite the discord in measuring ESG factors, reports on companies' ESG performance still provide useful information, which is why experts recommend looking at multiple ratings for a given company and understanding the underlying methodologies. Following a ratings firm's analysis of a single company over time also can provide useful insight.

Consider MSCI's ESG rating of Equifax Inc. MSCI lowered Equifax's rating in August 2016, citing a data breach at the company that resulted in the exposure of the personal data of employees at Kroger Co., the supermarket chain. The following year, in September 2017, Equifax disclosed that the personal information of as many as 143 million consumers had been exposed.

"We can't forecast the events themselves, but there are usually a series of indicators," says Remy Briand, MSCI's head of ESG.

Equifax declined to comment for this article.

Vladimir Demine is a portfolio manager for the international equity team at Morgan Stanley Investment Management and head of ESG research for the team. He views ESG scores as the first step in a broader analysis of the nonfinancial risks that could have a big impact on a company's bottom line. "You look at various sources of data," he says, "and then you try to solve the puzzle."

Ms. Broughton is a Wall Street Journal reporter in New York. She can be reached at kristin.broughton@wsj.com.

(END) Dow Jones Newswires

June 24, 2019 08:47 ET (12:47 GMT)

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