Unpacking MSCI's ESG Ratings

MSCI ESG Research downgraded the ESG government rating of Russia from Triple B to B, the second lowest rating, with a negative outlook with immediate effect this week. Prior to the invasion of Ukraine, Russia's political governance score was already assessed as being weak under the three categories of stability and peace, political rights and civil liberties, and governance effectiveness. Using the Sovereign Watch methodology, MSCI reduced these scores further in response to Russia's actions in Ukraine and now place it in the Very Severe category. In addition, MSCI initiated Very Severe Sovereign Watch assessments for Russia's economic environment and financial governance categories of the social and governance pillars.

The United Nations-backed Intergovernmental Panel on Climate Change (IPCC) released its third report on climate change. Researchers in the latest volume focused on the unpreparedness of nations to cope with climate instability and the impacts from higher temperatures, now at 1.1 degrees Celsius above pre-industrial levels. Among the findings in the 3,600 page report, the effects of melting glaciers are thawing permafrost in some areas and are approaching irreversibility. Half of the world is already living with severe water scarcity during part of the year. Worldwide rise in heat related illnesses and death, with more food borne and infectious diseases, can be expected without adaptation. Agricultural productivity has slowed, and weather extremes have put millions of people's food security at risk. As many as 14% of animal species studied will likely face a very high risk of extinction. Bringing temperatures back down after passing 1.5 degrees Celsius is an extremely difficult endeavor, according to the report, and would still leave potentially irreversible damage.

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Meet Meggin Thwing Eastman

Meggin Thwing Eastman is MSCI's ESG Research managing director and Global ESG editorial director with 23+ years of experience in the ESG field. Meggin is responsible for the company's ESG research agenda and global editorial strategy as well as oversight for ESG research content. She has authored numerous research insights providing guidance for asset owner and asset managers seeking to incorporate ESG considerations into their investment process. Her recent publications include ESG Trends to Watch (2020, 2021 and 2022), Human Capital Risks in a Changing World, and Institutional Investing for the SDGs (co-authored with the OECD). Meggin is also a regular commentator on MSCI’s ESG Now weekly podcast.

What's in This Episode?

ESG has become a very popular investing thing among investors over the past decade, the past year has brought into questions what ESG really means, how it's measured, and how to evaluate companies based on ESG criteria. Central to that question is whether or not environmental, social, and governance criteria are about a company's behavior or about its bottom line. Simply put, are ESG ratings just another scorecard for judging what a company does and its impact on the planet, its employees, and its customers or yet another measuring stick to measure one company against another?

MSCI was one of the original creators of ESG ratings, and they are widely cited and used across the investing landscape, but not without controversy as more investors pile into this theme. We're going to unpack what MSCI's ESG ratings are and what they're not with Meggin Thwing Eastman. She's the managing director, editorial director for ESG and Climate Research at MSCI, and thanks so much for joining us on the Green Investor. 

Meggin:

"Thanks, Caleb. Great to be here."

Caleb:

"So, let's get right to it. What's behind MSCI's ESG ratings? What really are they intended to do?" 

Meggin:

"Yeah. So an MSCI ESG rating is fundamentally a measurement of a company's long-term resilience to financially relevant environmental, social, and governance risk. So, very much in that financial relevance camp. It's a global industry-relative model, which means that we're looking at companies in comparison to other companies in the same industry around the world—developed and emerging markets."

"And what we're looking at there is the most financially relevant risks for each industry, which you can imagine can be quite different if you're looking, say, at a mining company. They need to pay a lot of attention to things like toxic emissions and worker health and safety and relations with the surrounding community. But those aren't the most significant issues at all for, say, an Internet services company. They've got to be thinking much more about privacy and data security and talent management and that sort of thing. So, our MSCI ESG ratings are looking at different issues for different industries, depending on what's most likely to materialize in ways that affect a company financially."

Caleb:

"I read your paper on this and you have a very good example. You just gave two, but semiconductors, which are so important, we call those the transports of the 21st century. We needed for absolutely everything. For the conversation we're having, for our refrigerators, for our cars, for everything else. But an ESG rating for a semiconductor company, like you said, very different from a mining company, very different from an Internet services company or a beverage company. Let's just unpack semis for a second because our I know our listeners understand those well."

Meggin:

"Yeah. So, if we're looking at semiconductors, that actually is a good way into another point I was going to mention, which is that we're looking at what's most important for the industry but also at the individual companies because they've got different business models, right? So, if you look at computer chip, semiconductors, you've got companies that own their own fabs and they're doing all of the manufacturing from start to finish. They're hugely water intensive. They are massive investments, billions of dollars to build a new one, so it's not easy to just pick it up and move it somewhere else. And then you've got other companies in the same industry that are just licensing IP, and somebody else is making the chips. And so, you can imagine that the risks that they're facing look really quite different from one to the next. And the way you need to think about it as an investor, again, is quite different."

"So, we might say water stress, really important to the semiconductor industry. Look at Taiwan over the last year; there was a drought, and it interfered with manufacturing. And we're feeling that partly along with other things, with the global supply chain and a difficulty to get rental cars in the U.K. where I live. So, it's very connected. But that risk is not affecting all the companies within the industry equally. And consequently, what those individual companies need to do to manage the risk is also different. So, if you're one of those companies with huge fabs in Taiwan facing water shortages, that's very different than if you're a company based in California that's just licensing IP and doesn't have a lot of employees, much less manufacturing facilities."

Caleb:

"And I know from having used your ratings and your ratings tools that if I put in a company like Taiwan Semiconductor or Nvidia, very popular stock here, very popular company, I'll get a different rating and a different reading because the way they operate is very different, right?"

Meggin:

"That's right. And so, what we're trying to measure with the ratings is not just, 'what kind of impact are they having on the world,' but in fact, 'how are these issues coming back? How could they come back to bite the company in ways that would affect profitability or valuation or volatility, things like that, down the road?'"

Caleb:

"So, in that respect, you're really creating a tool for investors to evaluate company performance and what a company's performance might be given those risks. Do I put that the right way?"

Meggin:

"That is exactly right. And this is for a use case in the investment world that we describe as ESG integration, which is really about incorporating this kind of financially relevant information that did, in a way, just happen to be about environmental or social or governance issues. It's basically about making sure, as an investor, that you're not missing important information that could affect your financial outcomes down the road as you make your investment decisions. And that could be positive information or negative information about any company. But that's really what you're solving for."

"But there are other things investors want ESG information for, and it's important not to mix those up because you want to make sure you're using the right kind of information, the right kind of tools for the job. If you're looking to hammer and nail, you want a hammer, you don't want a drill. But there are other things you might want a drill for."

Caleb:

"Great point and great analogy. So, this is the Green Investor. We're interested in environmentally sensitive investing for folks that want to invest along with their environmental conscience. And I know that's part of your ratings, but let's get into the climate-specific initiatives that MSCI helps screen for and how you're helping investors screening companies in and out of their portfolios or make decisions based on those ratings. Can you take us through some of that?"

Meggin:

"Absolutely. So, even within the climate space, thinking about the climate transition, climate risk, climate impact, there are a lot of different questions that investors might have to which ESG information, climate information, is going to provide an answer there. They're going to have different purposes or objectives."

"So, just to make list off a few things you might think: Do you want to know today's carbon footprint and how a company stacks up compared to its peers today? Do you want to know what its path looks like to 2050 and 1.5 degrees of warming or a net zero scenario? Because those might be really different things. Are you more focused on risk, company value? What might happen to company value as a result of its exposure to physical or transition risk as climate change manifests? Or maybe you're thinking about clean technologies, you want investment solutions. That's a really different exercise than trying to identify companies that own fossil fuel reserves or that have high emissions, something like that."

"So, there's lots of different kinds of information you could be looking at. And so, you really need to think through, 'What am I solving for here? What is it that I actually want to know?' Find the right information and then think about what you want to do with it. Do you want to point your money toward today's leaders, the companies that are best positioned right now? Or maybe you're focused on the potential up and comers, the companies that are not that close to being ready for 1.5 degree warming rise today, but they're on their way, and they need help to get there. Or maybe you want to engage companies that are really lagging and try to push them to do better. Or maybe you want to withhold capital from those companies and plug it into the companies that are inventing the clean tech solutions we're going to need for tomorrow."

"MSCI can help with all of those different things. We have, of course, data sets and assessments and so on. But it really is important in working with investors for us to understand what it is they're actually trying to do and then match up the right kind of data for that."

Caleb:

"And the investors you're talking about are, in large part, institutional investors moving tens and hundreds of billions of dollars around the world into their portfolios. But individual retail investors like me and our listeners, they can get onto your ratings, and they can plug in for those certain variables just the way I would if I was doing a stock screener for another industry, whether I care about profitability, whether I care about revenue growth, or if I care about these actual ESG issues. This is a tool to help you do that, and folks, we'll link to MSCI's tools so you can check them out for yourself because they're pretty fascinating."

Meggin:

"Same thing for funds."

Caleb:

"Right. Funds want to do the same thing. They have their criteria for..."

Meggin:

"We do rate funds as well."

Caleb:

"Great point. OK. So, what's missing in the industry? MSCI was early into this game, but what's missing in the industry in terms of climate-related tools and products, cause that's kind of what we're focused on here, that MSCI is maybe helping to develop or that you think we're going to need, given what is happening with climate change?" 

Meggin:

"Right. So, things have been moving very fast over the last couple of years. I say this as someone who's been in this field for two decades plus now, that the rate of change in what investors are trying to do and what research houses like MSCI are trying to do and industry organizations like GFANZ, the Glasgow Financial Alliance for Net Zero. There's just been a lot of action over the last year or two, so a lot of things have been developed that didn't exist even a year ago, and I think we're going to see a good deal more of that over the next couple of years."

"But if I were to highlight a couple of things where I think, collectively, we need more and MSCI is trying to contribute here, I'd say we need more convergence around forward-looking climate metrics, both in the methodology but also in market practice and adoption. Because, as I alluded to earlier, carbon footprints are useful to show you where you are today, whether that's your portfolio or an individual company or whatever, but they don't tell you what kind of track you're on. They don't tell you where you're going to be in a decade or three decades. So, we need companies to transition their business models or the whole climate transition just isn't going to happen."

"So, we need companies to transition their business models, and we need metrics as investors to make it easy to see who's working on it and making progress and who is not. And so, there are really key roles here for a lot of the organizations that have come together, whether it's GFANZ or the Science Based Targets initiative or the TCFD, the Task Force on Climate-Related Financial Disclosures. There's a lot going on, but there's still also not a ton of agreement yet. And so, I think we need to see more convergence there."

"MSCI launched a few months ago a metric called Implied Temperature Rise, which is designed along these lines, and it's designed based strictly on guidance from the TCFD, really trying to make this almost something in service of the public needs as well as investors needs here. And what it's trying to measure is where a company is going to be, if the whole economy behave like this company seems to be behaving, what would global warming be? How much would it be? That's expressed as a temperature. So, that's the sort of thing, there are others developing other metrics, and we're going to need to come around to more convergence on those."

"So, moving off that a second thing I would mention is regulation. So, this is not specifically a tool or a product. But dealing with the climate crisis is going to require system-level change, and that's got to involve regulators. And we need investors and companies. We need investors to influence corporates, and we need investors to influence both corporates and regulators to push things forward and to make it possible for companies and investors to take the action that's needed.

"So, MSCI is closely engaged with regulators around the world. We've really been staffing up on this topic specifically and especially as regards disclosures that could be required of companies or investors or financial products. But we're also very open with our clients and with the market on the point that decarbonizing a portfolio isn't enough. It isn't enough for the world and it isn't actually enough even to protect your own investments because we need the entire global economy to decarbonize. And investors have got a really big role to play there in pushing companies and pushing regulators."

"And, of course, this is at the core of what we do at MSCI ESG Research in terms of serving investors. So, if investors are looking to identify companies, to influence, to allocate capital, to withhold capital, to engage, etc., we've got all sorts of things from fossil fuel reserves and utility fuel mix data through some of the other things I was just talking about, implied temperature rise, carbon reduction targets, environmental management, oversight, all that stuff." 

Caleb:

"So our listeners know that we've been speaking to Engine No.1, and we talked to Follow This. These are companies or organizations that are trying to influence companies from the inside, and whether they're taking an active role like Engine No.1 or they're buying green shares like folks are doing with Follow This. But in many cases they're using your tools and your ratings as part of the argument for their position in these companies, which is why these ratings are so important. And you just mentioned a ton of acronyms in this industry, and we do a little segment on this show called Unpack the Acronym just because it is chock full of them. It's alphabet soup out there. Very difficult for individual investors to follow this and to keep track of the things that they think are the most important. So, maybe if we did a little un-acronym-ing of the industry, it might be helpful as well."

"Let's talk about some of the industries. Obviously, Big Oil is often targeted with criticism about ESG or sustainability, and for good reason. They're digging fossil fuels out of the ground, and that is definitely contributing to climate issues. So, if I go on to MSCI's ratings, I can compare oil companies against another and some may score higher, which for the individual investor may not be that intuitive. How could you even put a company like this in your ratings? But to your point, you have to, because these are investable vehicles, and there are criteria that you can measure a BP against a Chevron if you wanted to. Am I right?"

Meggin:

"Yes, you absolutely could. And in fact, we put out on a quarterly basis a report we call the Net-Zero Tracker, which looks at companies in the MSCI ACWI index, one of our large global indexes. And it'll stack up the companies with the highest emissions, the companies are the lowest emissions, the companies with the best new targets, the companies that have added new disclosures, that sort of thing."

"And I think it was in the last round of the tracker that came out (there's another one due out soon), but in the prior round, we actually did a side by side of Shell and BP, looking at their implied temperature rise. And it was this great, useful illustration of two companies that today both are extracting fossil fuels, they're extremely carbon intensive in their business, but they're on pretty different tracks towards the future as of now. Now, that could change. But if you look at that implied temperature rise, you can really see different paths over the next couple of decades that those companies might be taking."

"So, if you're an investor that's got the sort of constraints that means that you can't just exclude an entire sector, or maybe you don't want to exclude an entire sector. You want to say, 'You know what, we're gonna need energy. And so, let's invest in the companies that are really making that effort to transition their business away from fossil fuel and into things that will be more sustainable, rather than just cut off the whole sector.'"

Caleb:

"Super important at a time like now because energy stocks, as folks know, have been some of the best performers over the last several months. So, either you're excluding them from your portfolio altogether and you're missing that upside, or you're finding the companies that may fit best with the things you care about as an investor, and maybe they do belong because they are doing the right thing. But a lot of that remains to be seen because the energy industry and the complex itself has so much work to do to change its business model if it is going to participate in the reduction of global warming. So, this theme has evolved a lot in the past decade—ESG and and related themes. Where do you see it going in the next 10 years? What do you think are going to be the most important focus for MSCI and for investors in general?"

Meggin:

"That's a great question because if I look back just 10 years to where we were in 2012, it's kind of incredible. It's only been 10 years because so much has changed, and I think the pace of change in this industry is increasing and is still increasing. So, we're going to see new issues emerge, we're going to see existing issues that are a little more at the periphery today that are going to become central and material probably faster than we think. And one of the things I have in my mind there is biodiversity and nature and how integrated that is with the whole climate crisis situation. But I also think, if we focus more on climate, that the way we look at and measure and understand climate risks in the climate transition, it's going to continue to develop, again, probably even faster than it has been. And of course, in another 10 years, we're going to be much further along the road to that warmer future, and we're going to have a really good sense of how well we've done it, the goals that we're setting today. So, it could be quite a different picture then."

"But more generally, I think over the next decade, we're going to see that ESG and climate information and the investment process are unavoidable for virtually all investors. And especially climate change, because we're really past the point of whether you believe in it or not. The facts are there, the research is done, and the numbers speak for themselves in many ways about the relevance of these issues to financial performance and risk. So, I think there's that, that it's really going to become unavoidable even for the skeptics."

"There's going to be a lot more regulation of the industry and of companies. And what we don't know yet is whether those regulations are going to generally converge globally or whether we're going to see more fragmentation. And so, as we think about MSCI's roll in talking to regulators and trying to help them understand the institutional investor space and investors themselves engaging with regulators, this is going to be an important thing to see whether the regulations end up really kind of marching in the same direction or getting more specialized and fragmented in a way that that's going to create more burden for investors and make it harder to execute."

"And then finally, I think you alluded at the beginning, Caleb, to the growing pains that our industry is undergoing at present and the questions that are being raised as more people get into it. And I do think that over the next several years, we're going to get past that period because today there's a ton of interest in ESG and there's a ton of interest in investing for the climate, incorporating climate change considerations. But there's also a lot of misconceptions and misperceptions about what this all is and how it works. And I think that people are going to really, probably pretty rapidly, come to better understand a lot of the things that we've been talking about today in this interview. About different kinds of approaches and objectives and constraints, different motivations and so on. And so they're going to be able to come back and look at the right tool or the right tools for the job and, at the risk of straining the metaphor, to not object when their hammer doesn't do a good job of drilling holes."

"So, that's where I would see things going a lot more focus on climate change and getting more sophisticated really rapidly. A lot of development in the regulatory space. And I'm an optimist on this, getting past the current misconceptions, misperceptions, confusion in the ESG investing space to where it's just better understood and more mature."

Caleb:

"Education is such a key component of that. So, if there's one thing you could point our listeners to that they should read—folks just getting into this for the first time. A primer, a report, whether it comes from MSCI or elsewhere, that you would just recommend to investors just to get that fundamental understanding. Where would you point them?"

Meggin:

"I think if we're talking about climate change and the intersection of climate change and investing, I would point you to MSCI's Net-Zero Knowledge Hub, which is a free resource available to anybody on the public... you can just Google that. And there's a lot of information there. I had it going step by step, thinking about how to align investment portfolios better with less climate change rather than more."

"Beyond that, we do actually, on our own website, have a lot of basic information and introduction to what is ESG and what are different ways of thinking about it. So, that might be the first place. And if you're more interested in the big ideas and thematic concepts and where things might be going, every year we put out a report called ESG Trends to Watch for the coming year. And so some of the ideas I've just mentioned actually were in this year's report, which we published in December. So, again, you can just Google that. MSCI ESG Trends to Watch 2022. There's a paper, but there's also some cool interactive exhibits and videos and so on that I think are pretty accessible to a person who's not that deeply enmeshed in this industry."

Caleb:

"Great recommendations. You can Google that, folks, but we're going to put them in the show notes to make it easy for you. So, check out the Green Investor on Investopedia for a transcript of this interview and links to these reports. They're very useful, and I've read them both. Thanks so much to Meggin Eastman, the managing director and editorial director for ESG and Climate Research at MSCI. We really appreciate you joining the Green Investor."

Meggin:

"Thanks so much for having me."