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The Role of ESG Rating and Index Providers

Mainstream ESG rating and index providers, including MSCI, FTSE Russell, and S&P Dow Jones, are at the root of the ESG problem. Their current methodologies and practices lay the foundation for a system of ESG investing that undermines rather than promotes corporate accountability for social and environmental harms.  

That means they can help fix it.

Who are they?

ESG rating firms assess and rate companies’ performance across a range of ESG-related indicators—for example, CO2 emissions, worker rights and human rights. 

ESG index providers—in some cases the same firms—use those ratings to create and maintain ESG-labeled investment indexes, which are lists of companies that meet certain ESG-related criteria. Asset managers pay to access those indexes and use them to develop ESG-labeled funds, which they then market to investors looking to invest responsibly.  

MSCI, FTSE Russell, and S&P Dow Jones are among the most powerful firms in the industry because they create and sell both ESG ratings and indexes. They have also developed particularly close relationships with leading asset managers that rely heavily on their indexes. For example, BlackRock’s ESG investment funds are often modeled on MSCI indexes, while Vanguard tends to rely on FTSE Russell indexes. 

Increasingly, asset managers are creating funds that track specific investment indexes, making few if any changes to the companies included. This is called passive fund management, and it gives index providers even greater control over which companies benefit from ESG investment.  

What are they doing wrong?

One of the fundamental flaws in the mainstream ESG investing industry is the way that ESG ratings are produced. While each major ESG rating firm has its own methodology, they are problematic in similar ways:

  • ESG scores measure only financially material risk. Mainstream ESG rating firms only assess the ESG-related information that they consider financially material, meaning information they believe could impact a company’s profitability and value. In other words, ESG ratings—which provide individual companies sought-after access to ESG investment and the associated reputational benefits—are concerned only with ESG-related risks to a company’s bottom line and not its real-world impacts. 
  • Combined ESG scores conceal relevant information. The dominant approach to ESG rating is to combine environmental, social and governance factors into one overall score, meaning a company’s poor performance in one area (e.g., human rights violations) can be offset by unrelated actions in another (e.g., adoption of a new emissions reduction policy). 
  • ESG scores grade on a curve. Many ESG ratings firms assess a company’s performance only in relation to its industry peers. This means, for example, a mining company with an egregious human rights record can still score highly if other mining companies are doing even worse.
  • Scores overwhelmingly reflect company self-reporting and media coverage. Many ESG rating firms rely heavily on inherently biased corporate self-reporting to determine a company’s ESG scores. Supplemental research to identify “controversies” linked to a company usually focuses on media coverage, which means such controversies are only identified when there are news reports on them, and their impact on a company’s score will decrease if reporting on them declines. In other words, if the news cycle moves on from a controversial human rights incident, a company’s ESG score will rebound even if it does nothing to remediate the situation or even continues doing harm.   

What are their human rights responsibilities? 

ESG rating and index providers hold an exceptional amount of leverage over companies that want to be added to or remain on ESG-labeled indexes and in ESG-labeled funds. That leverage comes from their ability to facilitate or restrict investment in those companies, but also from their control over the reputational benefits that come with a high ESG rating and inclusion in ESG-labeled investment funds, including easier access to low-cost capital. 

Under international human rights standards, ESG rating and index providers have a responsibility to use their leverage to prevent or mitigate social and environmental harms. That includes the responsibility to conduct due diligence to identify abuses they are linked to and the responsibility to act when abuses are identified, including by downgrading implicated companies’ ratings and excluding them from their ESG indexes when problems go unresolved. 

Unfortunately, ESG ratings and index providers rarely do any of this. Systemic reforms are needed to ensure ESG index and ratings products adequately capture and reflect human rights concerns, and to align the ESG investing industry writ large with the UN Guiding Principles on Business and Human Rights. 

The good news is scrutiny from regulators and investors has increased in recent years. If leading ESG rating and index providers respond by making adjustments to their ESG-related products to meet the requirements above, it could ultimately lead to truly responsible investing options that provide sorely needed incentive for responsible business conduct and corporate accountability.