ESG ratings and the case of extreme human rights violations

ESG investment offers an opportunity to align investment decisions with values. The idea is simple and noble. An independent rater examines how a corporation performs along three key dimensions: environmental, social, governance (hence, ESG). Using these ratings, investors can put their money in responsible businesses. This idea has been wildly successful: more than 3,000 investors with a combined $100 trillion in assets under management have signed a commitment to use ESG information for their investments. Of course, reaching a verdict on a complex business is never easy, and hence ratings are only imprecise signals about a commitment to ESG. But these signals have the potential to be valuable. A high ESG score can open access to vast funding provided by pension funds, insurance companies, and other investors interested in supporting responsible businesses. Unsurprisingly, firms cherish their ESG scores.

Russia’s invasion of Ukraine, a massive shock to Russia’s human rights profile, exposes some limitations of the current ESG rating systems. The West responded with unprecedented sanctions to punish the aggressor and prevent the latter from supporting its army with new weapons. To reduce reputation risk, some firms such as McDonald’s and Coca-Cola halted sales either temporarily or indefinitely in the case of Starbucks. Others, such as Société Générale and Metro, decided to stay.

What happened to firms domiciled in countries respecting the rule of law that did not stop their business ties with Russia?

The reaction of MSCI, a major provider of ESG ratings, came almost immediately for Russian firms: most of them seem to be downgraded to a rating that makes it theoretically impossible to appear in an ESG portfolio. But what happened to firms domiciled in countries respecting the rule of law that did not stop their business ties with Russia? Put differently, how do we rate firms that are exposed to extreme human rights violations with only parts of their revenue stream? MSCI’s choices seem clear, as Société Générale stays stable at the highest possible rating AAA and Metro at AA. This inaction suggests several crucial problems with the current system of ESG ratings.

First, firms can substitute bad behavior with good behavior as most ESG ratings are linear weighted averages within sectors. For instance, Nestlé is a leader regarding Water Stress and Corporate Governance for MSCI. Hence, Water Stress can compensate for an abysmal human rights track record. And although Nestlé has taken stronger action in recent days, this substitution quandary for ratings providers remains.

Second, the measurement methodologies are not transparent. Users of ESG ratings have no ability to determine how the human rights record of a company is judged and potential exposure to risks. For example, products may end up in nefarious uses. Germany's Bosch, a major truck parts supplier, discovered that these parts were found in Russian military vehicles. Upon learning this information, Bosch halted deliveries, but the damage had been done. Without knowing how the raters assess Bosch, we cannot know in advance how such cases are treated. We also cannot productively scrutinize the raters’ methodologies.

Third, extreme human rights violations by a country are difficult to separate entirely from a firm. A firm that operates in such a country supports the regime through taxes. Similarly, a firm that operates in a regime where corruption is widespread might not be able to do business without engaging in corruption.

ESG raters should be more transparent. Some form of government regulation may be necessary.

How can we address these problems?

First and most importantly, ESG raters should be more transparent. Some form of government regulation may be necessary. The European Commission plans to seek stakeholder views on the use of ESG ratings by market participants and the functioning and dynamics of the market, while the SEC listed ESG rating practices as a key examination focus.

Second, MSCI and other ESG raters can provide more warnings about potential risks associated with specific businesses. For example, KLD, a provider of ESG scores acquired by MSCI and discontinued, issued flags for firms operating in questionable regimes (e.g., firms doing business with the apartheid regime in South Africa received those flags; similar flags were issued for firms connected to Sudan). These flags or similar warnings would give portfolio managers the ability to make an informed choice regarding their investments. This would also prompt quicker reactions when human rights records deteriorate.

Third, some issues are so significant, such as extreme human rights violations, that they should maybe not be able to be compensated by other issues. Indeed, some indicators could be capped by the sovereign score of the country where the firm operates. For instance, credit risk ratings agencies do not allow firms to have a much better rating than the sovereign and effectively cap these ratings. A mechanism like that does not exist for ESG ratings.

ESG investors are facing difficult choices and might be forced to overrule ESG ratings to realign portfolios with their values.

But what about ESG portfolio managers facing the difficult choice to override ratings today?

Portfolio managers need to assess what firms are exposed to Russia in their portfolios. They can use financial services data to figure out how much the firms in question are exposed to business in or with Russia by looking at the revenue streams. Then, it is just the act of downgrading the rating themselves. Furthermore, they could engage with ratings agencies, to discuss how ESG ratings methodologies should evolve.

In summary, the Russian war in Ukraine exposes important limitations in current ESG rating methodologies. ESG investors are facing difficult choices and might be forced to overrule ESG ratings to realign portfolios with their values. Undoubtedly, regulators and ratings agencies have improvements in their sights, however the current situation and powerful public sentiment has just made them considerably more urgent.

Dr. Yuriy Gorodnichenko is Quantedge Presidential professor at the University of California, Berkeley. 
Dr. Florian Berg is a research associate at the MIT Sloan School of Management.

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