Environmental, social and governance investing remains highly popular with the investing public. According to Morningstar research, sustainable mutual funds and exchange-traded funds attracted $69.2 billion in net inflows from investors last year.[1] At the same time, ESG investing has drawn the scrutiny of regulators on both sides of the Atlantic. For example, in April 2021, the Securities and Exchange Commission’s Division of Examinations issued a risk alert reflecting its review of ESG investing and highlighting staff observations from recent examinations of registered investment companies, private funds, and investment advisers offering ESG products and services. Meanwhile, in March 2021, the European Union adopted the Sustainable Finance Disclosure Regulation, which requires, among other things, that E.U. funds disclose to investors how they integrate sustainability factors in their investment decisions. We can expect more action from regulators with respect to ESG in 2022.

While advisers, funds, and boards can expect to be preoccupied with coming attractions from regulators, there are more basic aspects of ESG investing that also merit scrutiny from board members. For example, as the SEC noted in the ESG risk alert, ESG investing encompasses a variety of investment techniques, including:

• integration (considering ESG factors together with other factors, such as macroeconomic trends or company-specific factors);
• exclusionary screening/divestment;
• positive screening (screens in/best in class);
• impact investing (investment made with focus on measurable environmental-, social-, or governance-related benefits);
• engaging with issuers to encourage them to improve particular “E,” “S,” and/or “G” practices; and
• sustainable investing (investing in themes or assets that specifically pertain to sustainability).

The alert states that the variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors. Board members may want to consider asking advisers about the steps they are taking to address these issues.

However, before an adviser can implement an ESG strategy of any type, it must be able to measure and assess potential investments to determine whether each one is consistent with the selected ESG technique. One resource that many advisers use in assessing the “E,” “S,” and/or “G” bona fides of particular investments is a third-party ESG rating provider.  

What the Research Found

An ESG rating provider will collect and aggregate various data points regarding an issuer’s ESG performance. It will then calculate an overall ESG score, as well as individual environmental, social, and governance scores. However, rating providers’ ESG scores historically have been poorly correlated with one another.[2] Researchers from the MIT Sloan School of Management have found that the correlation among ESG ratings across a group of six different providers was, on average, 0.54, with a range from 0.38 to 0.71, whereas the correlation between two credit rating providers was around 0.99.[3]

These researchers discuss at least three different types of divergence: scope, measurement, and weight.

• Scope divergence refers to differences in the underlying components utilized to construct a weighting. For example, solar panels utilize silicon metal, which in turn must be manufactured utilizing metallurgical coal. If one rating provider takes into account a solar panel manufacturer’s impact upon the demand for coal in connection with the manufacturing of the solar panels, while another one looks only at the solar panel manufacturer’s impact upon the demand for coal as an energy generation source, the two providers’ ratings will differ.
• Measurement divergence refers to differences in the measurement of an underlying component that is utilized to construct the rating. For example, one rating provider may measure an issuer’s labor-management relations by the number of work days lost to strikes or other work stoppages, while another rating agency may measure labor-management relations by the number of unfair labor practice charges filed against the issuer.
• Weight divergence is defined as differences in the weightings of components that make up the ESG rating.

Interestingly, the MIT researchers conclude that scope and measurement divergence are responsible for the lion’s share of rating divergence among providers. The researchers also find evidence that an issuer that receives a high score from a rating provider in one category is more likely to receive high scores in all other categories of the same provider.

ESG rating providers have not escaped regulators’ attention. For example, in its most recent staff report on nationally recognized statistical rating organizations, the SEC’s Office of Credit Ratings noted that many credit rating agencies are also offering a number of ESG-related products and services.[4] The report expressed concern about, among other things, the potential risk for conflicts of interest if a credit rating agency offers credit rating and non-credit rating ESG products and services. Similarly, the European Securities and Markets Authority recently issued a call for evidence that “seeks to develop a picture of the size, structure, resourcing, revenues, and product offerings of the different ESG rating providers operating in the E.U.[5]” The call for evidence also solicits views and experiences from the users of ESG rating providers, as well as entities covered by ESG rating providers. While it is too early to predict the particular details of any proposal to regulate ESG rating providers, it is not too early to predict that regulators will attempt to regulate ESG rating providers.

Where the Board Should Focus

Board members overseeing funds that utilize ESG rating providers may be well served not to wait for the SEC or any other regulator to act before exercising oversight on how fund advisers are (i) assessing ESG rating providers; (ii) selecting among competing ESG rating providers; and (iii) applying ESG rating providers’ ratings to ESG strategies. As board members exercise their oversight responsibilities, they may wish to focus on topics such as:

• Why is the adviser selecting the ESG rating provider(s) that it is using?
• If an adviser is using more than one ESG rating provider to rate potential and existing fund investments, how is it determining which provider to use for which investments?
• Does the adviser ever override the rating of an ESG rating provider and utilize its own rating? If so, what circumstances would trigger an override?
• Has the adviser ever replaced an ESG rating provider, either generally or for a particular investment or category of investments? If yes, what triggered the replacement?
• Is there any dialogue between the adviser and the ESG rating provider(s) about topics such as events that trigger rating changes, changes to ratings methodologies, or changes to weightings within a rating methodology?

In doing so, board members should realize that they will not be operating from a blank slate as they formulate questions to pose. In particular, recent SEC guidance regarding oversight of proxy voting advisors and of pricing services can help guide boards as they exercise oversight over fund advisers’ use of ESG rating providers. Board members may wish to ask advisers to address, among other things:

• How the adviser assesses the qualifications, experience, and history of an ESG rating provider;
• How the adviser assesses the ESG rating provider’s process for considering rating “challenges,” including how it incorporates information received from rating challenges into its rating information;
• How the adviser assesses the ESG rating provider’s potential conflicts of interest and the steps it takes to mitigate such conflicts;
• How the adviser assesses the effectiveness of the ESG rating provider’s process for seeking timely input from issuers and clients with respect to rating factors, rating methodologies, and accuracy of information compiled;
• Whether the adviser investigates the nature of any third-party information sources that the ESG rating provider uses in formulating its ratings;
• How often the adviser reviews the ESG rating provider and whether the ESG rating provider is required to notify the adviser regarding business changes that could affect its rating business;
• How the adviser assesses the adequacy and quality of the ESG rating provider’s staffing, personnel, and/or technology;
• How the adviser monitors the extent to which potential factual errors, potential incompleteness, or potential methodological weaknesses in the ESG rating provider’s analysis materially affects the provider’s ratings; and
• Whether the adviser’s use of ESG rating providers in implementing its ESG strategy is consistent with its public disclosure of how it utilizes ESG rating providers.

ESG investing is still a relatively new phenomenon in the asset management industry, with the term being used to describe several different investment styles with various objectives and techniques. Moreover, the ESG rating provider industry is still in its infancy, with a low degree of correlation among ESG rating providers assessing a single issuer. This combination poses several risks, ranging from an investor purchasing a fund pursuing an ESG strategy that does not match the investor’s ESG objective to an unscrupulous adviser cherry-picking ESG ratings to build an ESG product that only superficially matches its ESG objective.

Fund directors’ oversight of how advisers use ESG rating providers is vitally important during a period when the popularity of ESG investing is combined with both a lack of clarity and precision about what ESG investing means in particular contexts and a seemingly random distribution of ratings issued by ESG rating providers.

Ethan Corey is senior counsel at Eversheds Sutherland. He has more than 20 years of experience in the financial services industry and is a seasoned investment management lawyer with deep knowledge in distribution issues (including FINRA rules) as well as those related to the Investment Company Act and the Investment Advisers Act of 1940. Earlier in his career, Corey spent 14 years as an attorney at a global investment management company where he was senior vice president and associate general counsel. In this role, he oversaw global regulatory initiatives and supervised the legal department's distribution, regulatory, and corporate group, which supported the company's institutional investment advisory business.