Of MSCI and Men04/22 GIB Asset Management
In John Steinbeck’s book Of Mice and Men, the character Lennie is a gentle giant who tends to hurt things when showing his affection. In the world of ESG investing, MSCI is a giant, as the largest provider of ESG indexes and ESG scores in the world. A recent Bloomberg article, The ESG Mirage, articulated their understanding that MSCI’s ESG scores reflect not the contribution of a company to the damage occurring to the natural world and society, but rather the role of regulation and environmental, social, and governance risks on impacting growth and profit of a company1.
Is MSCI in danger of unwittingly hurting the very movement of sustainability that it has enabled, by confusing buyers about the aims of its index and scores? Considering the size and reach of MSCI, it is worth exploring how actions by MSCI can affect sustainable investing.
What are MSCI scores? The ESG Mirage likens them to credit scores, as MSCI bestows letter ratings (such as AAA) on listed companies depending on MSCI’s view of their performance on a set of criteria related to ESG issues. Credit scores are often consistent between different raters, and have the specific goal of defining risk of credit default2. MSCI scores are frequently criticised for giving a misleading view on how sustainable a company is, as scores are often wildly different between ratings providers, and do not provide any indication on how damaging they are to the society or environment that they operate in3. There are other issues with MSCI’s overall ESG score; they combine together Environmental, Social, and Governance risk issues, they are industry-weighted on a relative basis, are largely based on the level of publically disclosed information, and can be gamed by companies.
This is harmful to sustainable investing as MSCI scores are increasingly being misused as the definition of what makes a sustainable company, and increasingly drive capital flow. The growing volume of money in active funds that largely rely on these ESG scores, ESG indexes and ETFs based on MSCI ESG scores are often used a proxy for the popularity of sustainable investing or used to describe the aggregate performance of ‘ESG’ stocks. As an example of MSCI’s high market share, ESG ETFs linked to MSCI ESG indexes had 73.3 per cent market share in August 2021, with $185bn AuM globally4.
In defense of MSCI, the scores are not designed to demonstrate how exposed a company is to sustainability-linked opportunities, rather “an MSCI ESG Rating is designed to measure a company’s resilience to long-term industry material environmental, social and governance (ESG) risks”5; in other words, to measure financial risk to the company, not its impact.
That is not to say that there aren’t positive effects. A companion piece to The ESG Mirage, How to get an ESG Rating Upgrade6, outlined ways to improve your MSCI ESG score, which included reducing employee turnover and setting an emissions reduction target. To the extent that companies want to improve their ESG score – which can often lead to increase in capital flow – encouraging companies to improve will have beneficial flow-on effects on the environment and society.
Perhaps then, a better way to think about ESG scores is not as credit scores, with their simple directive of understanding default risk, but as sell-side buy/sell/hold recommendations. There is rarely a consensus between sell-side recommendations, as they reflect a range of potential company outcomes, and investors – depending on their appetite for such qualities as growth or value – understand that not every ‘buy’ recommendation is for them.
Similarly, there are many different ways you could judge a company within a sustainable investing framework. You may decide to rank them on their activities – and how likely these are to be disrupted by ESG factors in the future. You may decide to judge them solely on their impact on the environment, or impact on the societies they operate in, or even whether the world as we know it will cease to exist if they continue their current actions. Once such judgements are made, you may decide to engage with them, or divest completely, or short their stock, or a combination of these actions and more.
A brief interaction with the industry of sustainable investing will convince you that there are as many definitions of ESG as there are investment professionals managing sustainable funds (and acronyms in their chart packs!). Ultimately, investing and sustainability occur in a vast spectrum of possibilities which will contain many correct answers. A lack of consensus on what sustainability is or how to score a company on its ESG risk reflects a healthy market of ideas and should not restrict us from solving the world’s sustainability problems.
As for MSCI – will their ESG risk scores give investors false comfort and undermine the sustainability movement? Investing in funds or companies based on MSCI scores may concentrate risk as they drive capital flow, have limitations in their understanding as they aggregate E, S, and G issues, and focus on risk and not impact. As we transition to a sustainable world ESG ratings will have some degree of positive effect, but they will always be one, and not the only, answer. In Of Mice and Men, the giant Lennie must work together with the smart George if they are to achieve their goal of an idyllic life on their own farm; it will take a concerted effort by all of society, consumers, regulators, corporates large and small, and governments, – not just investors – to deliver a sustainable world.
Our latest views
View our latest insights and news, as well as our research series on sustainable investments