Vladimir Putin’s invasion of Ukraine is shining a spotlight on the largely unregulated business of ESG ratings, after investments billed as socially conscious bought into a regime that’s now being accused of war crimes.
On the eve of the invasion, about US$9.5 billion in funds meeting European environmental, social or governance standards were in Russia, often on the basis of ratings from companies such as Sustainalytics and MSCI Inc.
While ESG raters weren’t alone in misjudging Russia’s belligerence, their exposure is particularly awkward given their analysts are paid to focus on factors such as democracy, human rights and other social and governance factors. Regulators are now calling for urgent work to clarify the myriad standards and practices being used to produce such ratings.
“We need to do some kind of rethinking here,” said Erik Thedeen, chairman of the Sustainable Finance Task Force at the International Organization of Securities Commissions, in an interview. “This disastrous war is an eye-opener. The whole ESG community needs to think through how to handle state-owned companies” in countries that violate human rights.
ESG raters crunch vast amounts of data on everything from water use to gender balance to arrive at a grade that can look similar to traditional credit ratings from firms such as Moody’s Corp. or Fitch Ratings. The difference: Credit ratings have evolved over decades, tend to be well understood by investors, and are regulated.
By contrast, there are more than 600 standards and frameworks, data providers, ratings and rankings that are working to measure ESG-related risks, according to the European Banking Federation, a lobby group. (Bloomberg LP, the parent company of Bloomberg News, also offers sustainability ratings and data. Additionally, Bloomberg has a partnership with MSCI to create ESG and other indexes for fixed-income investments.)
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Despite most raters marking Russia down for its record on suppressing dissent at home and aggression abroad, that wasn’t enough to stop it having a green light for ESG investing. MSCI rated it BBB until the Feb. 24 invasion. It subsequently cut the government grade to B, and then to CCC.
In an email, MSCI said Russia’s earlier rating, which benefited from a skilled workforce and an abundance of natural resources, had been “offset” by very low scores on political governance due to issues such as democracy, press freedom and political rights. The rating also had taken into account the annexation of Crimea in 2014, the company said.
IOSCO, whose members regulate the world’s securities markets, said in November that ratings companies should provide greater transparency on how they reach their conclusions and regularly review their methodology. The European Securities and Markets Authority is currently surveying the industry ahead of likely recommendations for regulating it.
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European Federation of Investors and Financial Service Users spokesman Arnaud Houdmont said Russian issuers and bonds should have been downgraded from an ESG perspective immediately after the country occupied Crimea in 2014. The Brussels-based nonprofit represents individual savers and investors.
In a recently released study, professors Elizabeth Demers, Jurian Hendrikse, Philip Joos and Baruch Lev (who recently retired from New York University’s Stern School of Business) questioned why companies were able to retain their high ESG scores after investing so heavily in Russia. Among other observations made was an absence of any statistical association between companies’ ESG scores and their exposure to Russia.
“If you’re an investor who has been picking stocks based on ESG scores under the assumption that your money is likely to be funding more socially responsible corporate behaviour, you should be very disappointed,” the professors wrote.
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In their defense, ESG ratings firms didn’t misjudge the situation in Russia any more than most other analysts and commentators in the West. Florian Berg, a researcher at the MIT Sloan School of Management who specializes in ESG ratings, said that while the industry needs reform, no one had a war on their radar.
“It’s hard for ESG ratings, they are just a reflection of what society thinks,” he said. “Three weeks before, the most pressing issue was climate change.”
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Without reform, investors risk repeating the mistakes they made in Russia. For now, the method by which ratings firms generate ESG metrics are often counterintuitive. For example, Sustainalytics gives a higher ESG rating to Russia than to Ukraine (It did so before the war and continues to do so now).
Simon MacMahon, global head of ESG at Sustainalytics, said the firm’s sovereign ratings are based on a country’s ability to manage its wealth, both in the form of natural and produced capital. The greater the wealth and the better a government handles it, the lower the ESG risk.
“We recognize that ESG ratings firms, and I think analysts of all types, really, could have been more forward-looking and perhaps quicker to raise a significant flag prior to Russia’s invasion,” MacMahon said.
Such ratings faced scrutiny even before Russia invaded Ukraine, amid wider questions as to the purpose of ESG: Is it a tool for avoiding financial risk or for improving the world? And seemingly contradictory ratings underscored the complexity of measuring environmental, social and governance factors.
The companies that provide ratings admit it’s exceedingly difficult to capture everything in a single score. To provide more guidance, ISS ESG identifies factors like human rights and free speech violations that investors can use to supplement ratings.
According to Kristina Rueter, global head of ESG methodology at ISS ESG, the onus is on fund managers and other stakeholders. The company rated Russia C- before the war, and hasn’t downgraded it since.
“Russia has long been flagged for various violations,” including its “authoritarian regime, violation of freedom of speech, violation of human rights, nuclear weapons, low scores on the global peace index,” Rueter said. “The current situation confirms the controversy assessment that we had.”
