At the end of March 2023, MSCI announced that the company will change its ESG rating methodology by removing the so-called adjustment factors (ESG momentum and ESG tail risk) from the calculation of the ESG Quality Score. These changes were made after a consultation with clients who noticed an upward shift in ESG fund ratings.
The upward shift was at least partly driven by the momentum adjustment—this factor had positive influence on the ESG Quality Score if the underlying company had disclosed improved E, S, or G practices. An increasing number of companies are starting to report on their E, S, or G practices or improving their reporting under the current demand for ESG data by investors. As a result, more companies received an ESG rating upgrade. These upgrades were magnified at the fund level by the momentum adjustment. This means that the removal of the adjustment factors will make the requirements to receive a top rating more ambitious and rigorous, as it is to be expected that companies will witness more downgrades than upgrades under the new scoring regime. Therefore, the new practice should be in favor of investors.
That said, it is clear that this change will have effects on fund flows, as those investors who want only to invest in top rated products will sell mutual funds and ETFs which will lose the top rating and buy into products which will stay in the top segment. These flows may also have impacts on the wider markets since mutual funds and ETFs with outflows need to sell the underlying securities to meet the liquidity demand from the outflows.
From my point of view these changes to the rating methodology of MSCI will increase the quality of the ESG ratings from the company. Nevertheless, actions like this show that ESG investing is still in the childhood phase and the providers of data and ratings need to adopt the ever-changing market environments to their methodologies and processes to maintain meaningful measures and ratings. As a result, all providers of ESG-related classifications, measurements, or ratings need to practice learning by doing to fulfill the increasing demand for high quality data and ratings by investors. This means that the respective providers need to review their methodologies constantly and should not be shy to implement changes needed, as this is necessary to keep the trust of investors in their measures and ratings.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
