About 31,000 funds are about to have their ESG scores lowered at MSCI, as the firm’s ratings unit works through a major overhaul of its methodology in response to feedback from market participants.
Clients had voiced concerns about “an upward drift in ratings across the fund universe”, which is now being addressed, according to MSCI ESG Research.
The measures include giving managers of swap-based exchange-traded funds six months to provide data on their underlying index constituents, which MSCI will start using to generate environmental, social and governance scores instead of collateral, it said.
The changes, which take effect at the end of next month, come as ESG score providers continue to draw criticism for using inconsistent methodologies that have yet to be properly regulated. That has made a crackdown on ESG ratings a priority for policymakers across jurisdictions.
The European Commission said last week it is planning to unveil new industry rules in the first half of this year, and the UK has just launched a consultation on the extent to which ESG raters need to be reined in by clear rules.
MSCI said its changes are not “linked to regulatory developments in the EU or elsewhere”. Instead, the company said the “methodology changes were driven by consultations with clients” and “based on market feedback”.
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Given the pressure to improve ESG analysis, MSCI said it now believes that the threshold required to receive a top rating of AA or AAA “should be more rigrous and ambitious”.
Institutional investors have already started weighing in.
“Any significant adjustment to a rating is likely to lead to investors re-examining their portfolio to establish whether the fund continues to deliver in line with their strategy and investment beliefs,” says Joe Dabrowski, deputy director of policy at the UK Pensions and Lifetime Savings Association, whose members oversee a combined £1.3 trillion ($2.13 trillion).
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MSCI said its new methodology means it will also include about 8,200 new fixed-income funds in its coverage universe, “along with their numerous share classes”.
After the changes have been pushed through, MSCI expects that only 0.2% of funds will be rated AAA, compared with roughly 20% today. The proportion of BBB-rated funds will rise to roughly 26% from 21%, while 44% of funds will carry an A rating, compared with just over 17% currently, it said. There will be a little over 22% of funds rated AA, compared with almost 33% today.
The changes will reflect a simpler methodology, whereby ESG quality scores will be based solely on the weighted average ESG score of the underlying fund holdings. Previously, the company had included an additional layer in its analysis, which it called an adjustment factor. The variable looked at the exposure to holdings with ESG ratings changes, as well as the exposure to holdings with B or CCC scores.
“Institutional investors that have a fiduciary duty to consider significant investment risks now often analyse the ESG characteristics of their funds’ investment profiles,” says MSCI. “Assessments of funds’ ESG characteristics can be an important input to the fund selection process, but to be useful for decision-making, assessments need to provide meaningful differentiation and a meaningful reflection of funds’ ESG exposures.”
