By the end of April of this year, Morgan Stanley Capital International (MSCI), one of the top providers of ESG ratings, intends to eliminate ESG ratings from the majority of funds in an effort to stop greenwashing. The index provider MSCI will downgrade many ESG-compliant funds due to increased pressure from authorities worried about greenwashing, which is becoming more prominent in the sustainable finance sector. 

What has been changed by MSCI? 

Even if funds that own the same underlying assets are rated highly, all synthetic exchange-traded funds (ETFs)  that use swaps to follow asset values will lose their ESG rating. In other words, fewer investments will receive an MSCI grade of ‘AAA’ or ‘AA.’ This will aid in lowering the volatility of the scores for ESG funds. Most physical funds, which directly hold portfolios of stocks or bonds, are likely to have their ratings lowered along with the shift in ETFs. 

The Index provider stated, “the [ESG] rating is calculated based on a fund’s underlying holdings data. In the case of swap-based ETFs, the underlying data MSCI receives in most cases is the swap collateral holdings, rather than the constituents of the underlying index that is tracked. Therefore, we will no longer rate swap-based ETFs until we have determined a method to consistently rate a swap-based ETF based on the constituents of the underlying index that it tracks.”

The shift will typically have the biggest impact on synthetic, swap-based ETFs, which, unlike physical ETFs, use a swap contract with a counterparty to replicate the performance of the underlying assets rather than actually owning those assets. Therefore, the swap collateral holdings will be considered to measure ESG ratings rather than the underlying index that it typically follows rather than the funds’ underlying holding. 

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Global Impact of MSCI’s move to reduce ESG ratings

In recent years, interest in ESG issues and ESG investing has grown significantly on a global scale. This unexpected move by MSCI will have an effect on markets all over the world, particularly for investors and businesses that have prioritised ESG in their daily operations. 

According to a report by Morningstar, for all net inflows into European ETFs in 2022, exchange-traded funds that are aligned with environmental, social, and governance outcomes made for 65% of the total. Similarly, one of India’s leading fund houses, Mirae Asset Group reported that the assets under management (AUM) of the Indian ETF market have increased fivefold since 2018. The change in how MSCI measures ESG ratings will harm conventional structures of measuring and reporting, as well as cause losses for businesses that have invested in funds that are thought to adhere to ESG-investing principles.  The changes will apply to all ETFs and mutual funds all around the globe. 

The interesting thing to note is that MSCI, which has $13.5 trillion in assets benchmarked against its indices, has yet to publicise the findings of a consultation on its ESG ratings. The change is still in the process of being implemented. As a result, the process becomes more difficult because it must first evaluate its own ESG ratings using the new standard before it can use the new adjustments that will take effect in April.

How does this change affect ESG ratings? 

We are conscious of the significance of ESG ratings in assessing a company's overall sustainability efforts. While this action is taken to prevent greenwashing, many genuine ESG-focused businesses will lose their ESG ratings and scale back on the sustainability rank, which is a critical component for a business's image and overall success. 

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Reduced ESG ratings can harm a company's reputation, deterring stakeholders and investors from supporting it, which will have an impact on long-term sustainability goals. They can also hurt overall business prospects and relationships because of lack of confidence in their ESG commitments.  Additionally, the modification will have an impact on physical funds' ESG ratings, which are exclusively determined by the ESG ratings of their underlying holdings and an adjustment factor, which is based in part on the fund's exposure to firms with rising rather than falling ESG ratings. The index provider is eliminating this adjustment factor.   

How To Compare ESG Ratings  

It can be challenging for a company to distinguish between material and non-financial risks. ESG ratings play a key part in assessing a company's financial security performance in relation to environmental, social, and governance issues. KnowESG provides a single place where you can directly compare publicly available ESG ratings data and reports to show how companies are performing.  

Search by sector or by specific keyword, for example ‘mining and metals’, to list relevant competitor companies. We use published ratings from MSCI, Refinitiv, and Sustainalytics, the three most prominent agencies, to provide a diversified comparison of different ratings approaches. 

Takeaway

While the MSCI news may come as a ‘shock’, it sets a healthy precedent for the reassessment of what constitutes effective, realistic ratings outcomes, and places more positive pressure on companies to perform their ESG reporting due diligence in good order. With so much speculation lately as to the viability of ratings systems in light of increased corporate greenwashing, we applaud the increased scrutiny MSCI’s move will likely bring.

In case you missed the link, compare ESG Ratings here.