Downgrades expected as MSCI amends methodology for ESG fund ratings

The ratings provider is implementing a new approach to swap-based exchange traded funds to give ‘more accurate assessments’ of ESG factors to investors.

MSCI’s changes to its methodology for rating environmental, social and governance funds are reigniting debate on how rating providers should best incorporate ESG credentials in their assessments of financial products.

MSCI said that about 31,000 funds will be impacted by a one-time downgrade once the changes become effective at the end of this month. The “enhancements” are designed to improve stability and transparency and raise the bar for funds to achieve the highest rating. 

“In this new era where improvement in ESG is the status quo, we believe that the threshold required to receive a top AA or AAA rating should be more rigorous and ambitious,” it added.

One significant change is to how MSCI assesses the sustainability credentials of swap-based exchange traded funds. Synthetic or swap-based ETFs employ derivatives to track an underlying index – unlike traditional ETFs, which hold the underlying securities of the index they are tracking.

Under the new approach, MSCI will calculate the ESG rating for swap-based ETFs on the underlying index holdings, whereas previously it was based on the funds’ collateral holdings. It said the change, which will become effective in six months, will deliver increased accuracy and provide a better picture of the funds’ exposure to ESG risks and opportunities.

One ESG analyst, who did not wish to be named, backed making it harder to achieve a top rating. “My general view is that the AAA category was too lenient before and included funds which aren’t really that ESG-focused,” they said.

“It makes a lot more sense to have AAA as a category which is reserved for the darkest green funds and sets a high bar to achieve. Shifting from AAA to AA shouldn’t be too much of a problem but downgrading from AAA to A would be,” they continued.

“I think lots of people have kicked off because their funds will be downgraded, but ultimately it’s probably a good thing.”

Another analyst who did not wish to be named told Sustainable Views that the move “seems like another sign of the sector maturing”, with “more stringent criteria because more companies are able to meet them”.

“Longer term,” they continued, “it’s a positive development for the sector if we have more credible rating and more issuers are able to meet these more stringent criteria.”

Sustainable Views reached out to other ESG rating companies asking if they are also considering changes to their methodologies. Moody’s, Fitch, Sustainalytics and Refinitiv did not respond.

In relation to the synthetic ETFs change, S&P Global Ratings said it does not offer ESG ratings on ETFs.

Till Jung, global head of ESG products at ISS ESG, the sustainable investment arm of Institutional Shareholder Services, said that their fund rating covers synthetic ETFs only if at least 65 per cent of their weighted holdings are equities and bonds covered by its ESG corporate or country rating but that, because most synthetic ETFs would be “heavily” invested in derivatives, they would tend to be excluded from the rating. 

“However, to the extent we cover synthetic ETFs, we have always done so on the basis of the actual holdings, not on the basis of the index they are tracking,” Jung added.

MSCI said its methodology changes were implemented following exchanges with clients and not instigated by regulatory developments in the EU or elsewhere.

However, the market for ESG ratings is facing increased criticism over a lack of transparency and accuracy regarding methodologies and working practices. Concerns have attracted the attention of financial regulators, with both EU and UK supervisory authorities currently consulting on the matter.

While the UK Financial Conduct Authority is looking to establish a code of conduct for ESG data and rating providers, the European Securities and Markets Authority is also reviewing how derivatives should be treated under the European Sustainable Finance Disclosure Regulation.

Esma said the consideration of derivatives under SFDR is “paramount, to avoid greenwashing”. It added that derivatives could be at risk of greenwashing if used with the intention of overestimating a financial product’s taxonomy alignment or share of sustainable investments or, conversely, if they are excluded in order to underestimate the principal adverse impact indicators of an investment. 

Additional reporting by Alex Janiaud

This article was updated on April 20 after publication to specify that the MSCI ESG methodology change for synthetic ETFs will become effective in six months, and to add a response from S&P Global Ratings.