How to Tell if Your Investment is Really Responsible. By Jacqueline Poh and Emily Chasan.

The boom in responsible investing worldwide throws up a key question for borrowers, fund managers and index compilers: How exactly do you evaluate and compare responsible investments? A whole industry has grown up to try to provide answers. It looks beyond financial performance to score companies and investments on criteria including their environmental friendliness, social impact and governance -- shorthanded as ESG. ESG ratings are increasingly taken into account in decisions on where to invest or allocate capital. But there’s debate over whether they can truly buffer against financial risk or even act as a guide to better-performing investments.

1. What are ESG ratings?

They help companies, investors and other finance professionals factor environmental, social and governance criteria into their decisions. They can help gauge whether a company is a global citizen, or how well it’s handling risks with potentially costly consequences. A rating can cover a long list of diverse factors including carbon emissions, water usage, gender equality, fair labor practices, human rights, crime-prevention controls, board composition and shareholder rights. There’s no single method for scoring or ranking companies. Some ratings companies rely on analysts, while others focus on quantitative information or company-provided data. They can analyze a company or fund for how transparently it reports such issues, or how well it stacks up against competitors or its own performance over time.

2. How are they used?

ESG scores can play a key role in determining whether fund managers or exchange-traded funds can buy a stock, how much companies pay on loans and even whether a supplier can bid for a contract. They can also determine whether a bond is really “green” or if a company is eligible for a stock benchmark. They’re in demand more than ever with the explosion in investment products that are marketed as being environmentally and socially responsible in their objectives. More than 1,500 investment managers have signed up to the United Nations Principles for Responsible Investment. The trend has driven a surge in the number of ESG indexes, making it the fastest-growing part of the market.

3. Who does the scoring?

The list of third-party companies that do ESG ratings, from Sustainalytics to MSCI Inc., is much longer than the handful of firms that dominate more traditional credit and mutual fund ratings. Some collect broad market data, while others focus exclusively on environmental factors or rating green bonds. At least a dozen different companies’ ratings have been tied to ESG incentives on loans and bonds. Sustainalytics provides ratings for about 70 of the more than 100 ESG-linked loans completed since 2017. Larger financial-services companies have expanded into the field by developing in-house ratings, striking partnerships or making acquisitions. MSCI’s ESG ratings are used by big investors such as BlackRock Inc., often as a basis for their ETFs. Credit-ratings companies such as Moody’s Investors Service also assess ESG risks to help measure creditworthiness. (Bloomberg LP, the parent of Bloomberg News, provides ESG data, analytics and indexes.)

4. How are ratings compiled?

Ratings providers mine whatever information they can get from companies, along with public sources such as news articles and reports by governments and non-governmental organizations. They assess companies across a range of areas often reflecting priorities laid out in the UN Sustainable Development Goals. Data is an issue because reporting standards vary widely around the world. Then they weigh different factors to generate an overall score. There’s debate over whether the system is biased toward larger companies with more resources to spend on gathering and reporting the data, which allows them to score well when being judged on transparency. In contrast to credit ratings, ESG ratings providers tend to be paid by the users of the data, such as fund managers, rather than by the companies being assessed. That is changing somewhat, particularly when ratings are used in ESG-linked loans and green bonds.

5. How do ESG ratings differ?

The key difference between ESG ratings is weighting, which can vary widely by industry. Pollution, for instance, is more of a risk for a power company than a law firm. But providers can also come up with different ESG scores for the same company if, for instance, one focuses heavily on labor standards and another places more importance on environmental factors. Ratings can throw up some unexpected readings too, depending on what’s being measured and how. Tobacco and oil companies can get good ESG scores if they’re assessed on the transparency of their disclosures. It can also be confusing to compare ratings from different providers. A score of 100 is the worst at Sustainalytics and the best at EcoVadis, while another provider, ISS-oekom, uses letters.

6. How big is the ESG market?

It’s still relatively small, but growing fast. Debt financing based on ESG criteria is now worth more than $150 billion, according to BloombergNEF. Sales of loans with interest rates linked to ESG rose 63% to $44 billion in the first six months of 2019. U.S. exchange-traded funds that use ESG criteria attracted a record $4.1 billion in the first half of 2019, according to Bloomberg Intelligence. A survey found that fund managers representing more than $21 trillion in assets have adopted, or are planning to adopt, ESG criteria. The market for ESG data and ratings will grow to a projected $745 million next year, an increase of almost 50% from 2018 and up by almost 300% since 2014, according to estimates by capital markets consultant Opimas.

7. What are the challenges?

Some investors have questioned rating methodologies, saying they can be vague or opaque. And favorable ratings don’t always weed out costly risk. The ESG ratings industry is also much less regulated than the world of credit ratings, with no official standards and qualifications. This may be starting to change with the European Union’s efforts to create a voluntary responsible investing framework, including officially recognized green-bond verifiers, which could become a global standard. The Sustainability Accounting Standards Board (SASB) has also developed industry standards to help identify topics that can have a financial impact on companies and investors. (Michael R. Bloomberg, the founder and majority owner of Bloomberg LP, is the chair emeritus of the SASB Foundation Board and another Bloomberg executive, Mary Schapiro is the vice chair.)