ESG Ratings Methodology
What is an ESG Rating?
An ESG rating is a comprehensive measure that aims to assess a company’s exposure to long-term environmental, social, and governance risks. These ratings are based on information that is not typically captured by traditional financial analysis and serve as an important data point investment managers can use to screen and assess companies in their portfolios. There are several established ESG ratings providers such as Sustainalytics and MSCI that investment professionals can rely on. However, their methodologies differ. ESG ratings are also regularly used in the media, where companies are labeled as “sustainable” or “unsustainable”, as well as by regulators who might monitor for issues such as “greenwashing” (putting forward sustainability credentials that are misleading). As the awareness around ESG grows, these ratings are even used by job seekers, many of whom are increasingly concerned with the values of the companies they choose to work for.
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Key Learning Points
- ESG ratings are granted by ESG Ratings providers to provide a quantifiable measure for aspects of a company that are intangible.
- ESG ratings methodologies consider the company’s exposure to various issues around environmental, social, and governance factors, the risks related to those factors, and how these risks are managed.
- The mismanagement of such risks is typically described as a “management gap” and is negatively reflected in the company’s ESG rating.
- Investment professionals use these ratings as part of their investment assessment and screening processes.
- A key issue in the ESG ratings space is the lack of a standardized framework applied across all methodologies, including consistency in reporting and data integrity.
How are ESG Ratings Determined?
The main objective of ESG rating providers in generating scores is to quantify intangible aspects of a business, which can prove difficult to measure. Therefore, an ESG score should be viewed realistically and considered a starting point rather than an absolute indicator. An ESG score is intended to help investors identify and understand financially material ESG risks to a business.
For example, Sustainalytics’ ESG Risk Ratings aim to measure the exposure of a company to industry-specific ESG risks. In addition, they try to determine how well the company is managing those risks. This method uses five categories of severity: negligible, low, medium, high, and severe. The assessment is guided by different factors, such as the company’s business model and financial strength, geography, and incident history. In order to allow investors to better compare the profiles of companies across their portfolio, Sustainalytics built a model in which exposure and management scores for different issues can be combined (or compared with each other).
Most information used to evaluate a company is publicly available. Since there is no specific requirement for companies to include ESG metrics in their reporting, it can be a challenge to obtain relevant data. Many large companies typically publish a separate sustainability report, but reveal only what they consider relevant, while smaller companies that lack resources may not report any ESG-related information.
Access the free download to see an example of an ESG rating report from Sustainalytics and Ratings Risk map.
What is an ESG Framework?
ESG frameworks are voluntary systems for standardizing the reporting and disclosure of ESG metrics. Although not mandatory, they can be required by specific investors or regulators in certain regions (mostly in Europe). ESG frameworks have been developed by industry business groups, non-profit organizations, and other international bodies such as the Global Sustainability Standards Board (GSSB); and therefore, their focus, metrics used, and recommendations may vary significantly. The Global Reporting Initiative is one of the most popular ESG frameworks that supports organizations in evaluating and communicating their impact on key issues such as climate change or human rights. Quantifiable metrics that can be reported under this framework include carbon emissions from operations and suppliers, working conditions, fair pay, financial transparency, etc.
Who Calculates ESG Ratings?
As already noted, there are established ESG ratings providers such as Sustainalytics and MSCI. Others include:
- S&P – produces a Global ESG Rank that yields a total sustainability percentile rating.
- Institutional Shareholder Services (ISS) – provide a governance score that assesses a company’s corporate governance practices.
- Bloomberg – provides an ESG disclosure score that is a proprietary rating based on a company’s ESG disclosures.
ESG Rating Methodology Comparison
Like Sustainalytics, MSCI ESG ratings are calculated busing a rules-based methodology. Companies are rated on a scale of AAA to CCC in terms of exposure to ESG risks, while also factoring in how well the company manages those risks compared to their peers.
To be considered a leader, a company must be ranked AAA to AA, which means that it manages the most significant risks and opportunities well. In contrast, companies ranked B and below (down to CCC) are considered “laggards” as they have high exposure to ESG risks. Companies that fall in the middle of the ranking (A, BBB, and BB) are considered to have an “unexceptional track record.” The specific measures used include more than 35 different elements around environmental, social, and governance concerns, for example, carbon emissions, waste, and tax transparency.
Criticism of ESG ratings
Although assessing a company’s ESG credentials can provide a good source of information and highlight its weaknesses and strengths, there is a lack of consistency between the rating scores of different providers. This is mostly due to differences in the methodologies used, which are not standardized across the sector. For example, as two of the most popular ESG rating providers, Sustainalytics and MSCI ratings should be highly correlated, but the correlation is currently below 50%. S&P and Sustainalytics ratings are more correlated but still lower than expected.
Nevertheless, the consensus is that companies that focus on environmental, social, and governance factors are in a better position to yield benefits. These may include better financial performance, easier access to capital, and lower operational and reputational risks.
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