S&P Global downplays its ESG ratings. Will rival ratings firms follow suit?

S&P Global, a premier financial data company, has recently put an end to its quantitative environmental, social, and governance (ESG) rankings. Rather than issue numerical scores across a scale that ranks a company’s activity with respect to ESG goals, S&P will now provide narrative, written scores. This decision comes at a time when political pressure on ESG investing theory among federal and state GOP policymakers has reached new levels.

As one of the most widely sought-after providers of business information and investing analytics in the public markets, S&P’s move may have a significant impact on the reputation of ESG services. S&P’s decision is currently at odds with rival rating firms like Moody’s and Sustainalytics, which still continue to use a quantitative scale when ranking companies.

ESG topics are generally nonfinancial in nature, and include a wide range of characteristics relating to climate change, workforce diversity, and various political positions, exhibited by each ranked company. The range of scores used by firms varies widely between ratings firms, as does the underlying methodology, weighting, and criteria used to score companies.

S&P’s ratings practice scored a company’s response to risk factors associated with ESG topics. Companies ranked highly received a score of 5, and were viewed as low risk in their corporate efforts on sustainability, social responsibility, and governance. By contrast, companies that received a score of 1 were generally those that lacked adequate risk standards to address ESG-related issues.

Despite the present hype over ESG, S&P’s reputation for its corporate debt ratings eclipses its ESG scoring. The firm is more widely recognized for issuing annual bond ratings for public companies and rating the creditworthiness of the U.S. federal government.

Regarding the latter, S&P issued a high-profile report downgrading the American government’s debt rating from AAA to AA+ in 2011. This came after a contentious political debate between the GOP-led House and the Obama administration over raising the debt ceiling that nearly led to the nation’s first ever default. S&P’s debt ratings are closely watched by analysts and are held in similar high regard as other credit rating firms like Moody’s and Fitch, both of which also issue ESG scores.

S&P’s decision to drop its traditional ESG scoring comes shortly after the Republican-led House Financial Services Committee wrapped up its “ESG month” in July. The committee hosted a series of ESG-specific hearings, shedding light on many of the most controversial aspects of this form of investing, including the myriad of issues associated with ESG rating firms. For instance, the committee’s July 12^th hearing echoed findings from the Republican ESG Working Group’s report on how major ESG rating firms often issue scores in a manner inconsistent with the financial performance of an ESG fund category.

The committee’s report cites a study which found that funds with low sustainability ratings actually outperformed those with higher ratings, casting serious doubt on the predictive ability of ESG ratings to assess financial performance. Another quandary for ESG rating companies, and S&P specifically, is the issue of how scores can at times be detached from a company’s actual perceived contributions to ESG.

Electric car manufacturer Tesla recently received a low ESG score of 37, which was 47 points lower than Marlboro maker Philip Morris International, a cigarette maker, and 51 points lower than British American Tobacco. Perplexed by this, Tesla founder Elon Musk tweeted in June, “How could cigarettes, which kill over 8 million a year, be deemed a more ethical investment than electric cars?”

Beyond the relative inconsistencies of ESG scores, negative scores often produce detrimental financial impacts on businesses and retail investors. Negative ESG scores can translate into a downgrade for a firm’s credit rating, inhibiting their future ability to qualify for loans. A study found evidence that varying ESG scores issued by rating firms can produce a substantial impact on a company’s overall credit rating. Credit raters assess ESG scores when arriving to the estimation of a company’s default risk.

Similar to how the range of methodologies used to rank a company vary between ESG rating firms, so to does the relative impact of their scores vary. Within ESG, environmental factors were found to impose the most pronounced impact on a company’s score, while factors pertaining to social responsibility were less relevant.

A more pronounced example of how ESG scoring can negatively affect the cost of credit is found with the practice of “sustainability-linked loans” (SLL). These green-based loans determine how much a company will be required to pay on borrowed money based on the level of its ESG scores from top rating firms.

The concept is simple: the lower a company’s ESG score, the higher its interest rates will be on loan repayment, whereas the higher a company’s score, the lower its interest will be. SLL loans first emerged in Europe back in 2017 and have become increasingly popular in the U.S.

S&P’s decision to backtrack its ESG scoring provides a promising sign of corporate unease with ESG. S&P’s decision arrives just one year after the Republican state attorney general of Missouri opened a multi-state investigation into controversies stemming from the firm’s use of ESG factorization when issuing ratings. In arriving at its decision, S&P issued a statement that confirmed the firm’s commitment to promoting ESG principles across its analytical services.

“The ESG credit indicators were intended to illustrate and summarize the relevance of ESG credit factors on our rating analysis,” S&P’s statement read. “This update does not affect our ESG principles criteria or our research and commentary on ESG-related topics, including the influence that ESG factors can have on creditworthiness.”

S&P’s ratings are among the most impactful in the credit-rating industry when assessing how costly a company’s borrowing costs will be from low ESG scores. Subjective, varying, and widely contradictory ESG scores do not represent a reliable means of assessing a company’s credit worthiness.

This move will serve to reinforce the arguments raised by ESG skeptics against the unreliability of equating such scores with predictors of financial performance. Additionally, ESG scores are often widely inconsistent indicators of a company’s actual contribution to environmental sustainability, social responsibility, and equity across governance.

S&P’s decision may trigger other firms to either deemphasize or drop their ESG rating systems entirely. What has become clear is that ESG ratings are not as useful or reliable as once believed.