Rating Objectivity: The Confusions in Nordic ESG Ratings ESG Ratings Subjectivity and its Consequences MASTER THESIS WITHIN: Business Administration NUMBER OF CREDITS: 30 ECTS PROGRAM OF STUDY: Civilekonom AUTHOR: John Rydholm & Samuel Schultzberg Bagge TUTOR: Fredrik Hansen & Toni Duras JÖNKÖPING May 2020 Master Thesis within Business Administration Title: Rating Objectivity: The Confusions in Nordic ESG Ratings - ESG Ratings Subjectivity and its Consequences Authors: John Rydholm, Samuel Schultzberg Bagge Tutors: Fredrik Hansen, Toni Duras Date: May 2020 Key terms: ESG, CSR, Ratings, Rating agencies, MSCI, Thomson Reuters, Sustainalytics, RobecoSAM Abstract: Environmental, Social and Governance measurements have significantly increased in usage due to growing concerns for environmental and sustainability problems in today’s world. However, with no commonly agreed-upon criteria for ESG ratings, the scoring measure creates confusion both at the investor and company level. Besides, ESG agencies have different processes and parameters for measuring ESG compliance, which contributes to the problem. The study examines four ESG rating agencies’ rating models and ESG scores to get a better understanding of deviations in ESG scores among Nordic companies. By also studying the correlation amongst ESG scores and market capitalizations in firms, the paper hopes to shed light on if any relationships exist between them. Our results show that the four major ESG raters in the study showed a weak to a non-significant correlation against each other. The maximum correlation found was 0.419 between Thomson Reuters and MSCI. RobecoSAM and MSCI showed the lowest significant correlation at 0.291. Sustainalytics was detected not to show any significant correlation with the other raters. Correlation among market capitalization and ESG Raters was detected to not correlate to a greater extent. Only one ESG rater, RobecoSAM, showed a significant size to score-correlation at 0.278 with market capitalization. Thus, market capitalization does not seem to have any significant influence on ESG agencies’ decisions to set scores. Précising the study’s findings, the raters’ methods deviate from one another, but also how ESG raters make use of underlying factors. i Acknowledgments We would like to thank our supervisors Fredrik Hansen and Toni Duras, for the support they have given us throughout the process of producing this paper. Jönköping University 2020-05-18 John Rydholm & Samuel Schultzberg Bagge ii Table of Contents 1 Introduction ......................................................................................... 1 1.1 Problem Background ..................................................................................... 1 1.2 Problem Discussion ....................................................................................... 2 1.3 Purpose ........................................................................................................... 3 1.4 Research Question ......................................................................................... 3 1.5 Delimitations .................................................................................................. 4 2 Frame of Reference ............................................................................. 4 2.1 Institutional Theory ........................................................................................ 4 2.2 Signaling Theory ............................................................................................ 5 2.3 Theory of Rating ............................................................................................ 6 2.4 Theory of Effective Regulation ..................................................................... 7 3 Review of Related Literature ............................................................. 8 3.1 Definition of Environmental, Social and Governance ................................... 8 3.2 Definition of Corporate Social Responsibility ............................................... 9 3.3 ESG .............................................................................................................. 10 3.4 Rating Agencies ........................................................................................... 11 3.5 Divergences in ESG ratings ......................................................................... 13 3.5.1 Rater-effect ....................................................................................... 14 3.6 ESG and its Effect on Firm Valuation ......................................................... 15 3.7 ESG Regulation within the European Union ............................................... 16 3.8 Regulation of ESG Agencies ....................................................................... 17 4 Methodology/Method ........................................................................ 18 4.1 Collection of ESG Ratings ........................................................................... 19 4.2 How ESG Raters Produce Ratings ............................................................... 22 4.2.1 MSCI ................................................................................................ 22 4.2.2 Thomson Reuters .............................................................................. 24 4.2.3 RobecoSAM ..................................................................................... 24 4.2.4 Sustainalytics .................................................................................... 25 4.3 Selection of Data .......................................................................................... 26 4.4 Management of ESG Data ........................................................................... 28 4.5 Spearman Rank Correlation ......................................................................... 29 4.6 Market Cap and ESG Score ......................................................................... 29 4.7 Case Study ................................................................................................... 30 iii 5 Empirical Findings ............................................................................ 31 5.1 ESG Correlation Results .............................................................................. 31 5.2 Market Capitalization and ESG Rating Correlation .................................... 32 5.3 Market Capitalization Differences ............................................................... 32 6 Analysis .............................................................................................. 34 6.1 Quantitative Analysis ................................................................................... 34 6.1.1 Correlation ........................................................................................ 34 6.2 Qualitative Analysis ..................................................................................... 36 6.2.1 Qualitative differences ..................................................................... 36 6.2.2 Input Sources .................................................................................... 37 6.2.3 Peer Comparison .............................................................................. 37 6.2.4 Rating Model Variables ................................................................... 38 6.2.5 Rating Methodologies ...................................................................... 39 6.2.6 Change in ESG ratings ..................................................................... 39 6.3 Regulation .................................................................................................... 41 7 Conclusion .......................................................................................... 42 8 Discussion ........................................................................................... 43 8.1 Practical Contribution of the Study .............................................................. 45 8.2 Further Research .......................................................................................... 45 9 Ethical Considerations ...................................................................... 46 10 References .......................................................................................... 48 11 Appendices ......................................................................................... 53 11.1 Appendix A ............................................................................................... 53 11.2 Appendix B ............................................................................................... 54 iv List of Tables Table 1. Population Characteristics ........................................................................... 27 Table 2. Common Sample characteristics ................................................................ 27 Table 3. Transformation of MSCI AAA-C Scale Into 1-100 .................................... 28 Table 4. Spearman Rank Correlation Test – ESG Raters ....................................... 31 Table 5. Pearson Correlation – ESG Rating/Market Capitalization ..................... 32 Table 6. Spearman Rank Correlation – ESG Rating/Market Capitalization ....... 32 Table 7. Descriptive Statistics over the data samples. ............................................ 32 Table 8. Largest and Smallest Firms (Market Capitalization) in Overall and Common Sample ............................................................................................ 33 Table 9. Overview of Findings