ESG Investing 101: Understanding ESG Ratings

  • An ESG score quantifies a company’s risk with respect to the environment, internal society and corporate governance.
  • Each of the ESG score providers has its own proprietary methodology for compiling these scores.
  • A good ESG score indicates that a company’s environmental, social and governance risks are very low.

ESG Scores are essential tools for investors practicing ESG investing. If you want to incorporate your values ​​into your investment strategies, ESG scores can help you assess a company’s commitment to the three legs of the ESG scoring model.

ESG stands for Environmental, Social and Governance and investors apply these non-financial factors as part of their risk analysis.

Companies use the ESG score to measure their exposure to ESG risks over the long term. As public and shareholder pressure mounts on corporations, weighing ESG risk becomes increasingly important for both investors and companies.

What is an ESG score?

An ESG score measures environmental risks, such as energy efficiency, social risks, including worker safety, and governance risks, typically measured by board diversity. These measures are not normally part of traditional financial analysis.

Companies with strong ESG ratings manage these risks well compared to their peers. A weak or low rating suggests unmanaged risks that can negatively impact a company’s reputation and bottom line. However, ESG ratings are not a substitute for financial analysis, but rather an extension of that analysis that covers areas of risk that are increasingly becoming part of a company’s potential.

How are ESG scores calculated?

Investors and companies alike turn to ESG rating agencies, third parties, and unrelated companies that specialize in ESG scoring. Prominent players in this space include MSCI ESG Research, Sustainalytics, Bloomberg ESG Data Services, and others. Overall, more than 140 rating firms provide exclusive ESG scores to investors and companies.

“Because each ESG data provider uses a different set of criteria to assess a company’s ESG performance, it makes it very difficult for investors to get a clear picture of how different companies rate on their ESG performance,” says Daphne Biliouri-Grant, Senior ESG Advisor at Sibylline Ltd., a UK-based strategic advisory firm. “Establishing a consistent and transparent reporting framework is a priority, so investors can get a realistic assessment of how companies are performing within the ESG space.”

Using proprietary analysts and algorithms, ratings firms convert metrics like a company’s carbon emissions, employee safety procedures, and board diversity into environmental, social, and governance scores, which are then amalgamated in a single primary rating.

MSCI, for example, examines hundreds of metrics and assigns a score from 0 to 10 to each company on each major issue. Problems are weighted based on timeliness. Those with the greatest potential impact two years from now have the highest weights. Those with an impact timeline of five years or more have low weights. Ratings range from a low of CCC to a high of AAA. Ultimately, MSCI classifies companies as Leaders, Average, or Laggards.

“One of the challenges and setbacks against MSCI is that their scores are given based on the performance of their peers and are not absolute, so a company in an energy-intensive sector just needs to score better than average. “, says Max Messervy, director of Mercer. of Sustainable Investment, Americas.

Sustainalytics, a subsidiary of Morningstar, provides ESG ratings to 20,000 companies in 172 countries. Based on both quantitative ESG data and qualitative analysis, ESG Ratings cover a number of different areas, including governance, environmental impact, social contribution, and financial performance to provide a holistic view of a company’s ESG profile. The risk ratings cover five categories: negligible risk (0 to 9.99), low risk (10 to 19.99), medium risk (20 to 29.99), high risk (30 to 39.99), and severe risk. (40 and over).

For comparison, the table below lists the ESG scores of various companies using MSCI and Sustainalytics ratings. In some cases, both MSCI and Sustainalytics rate the company as medium or medium ESG risk. In others like AES Corp, MSCI rates the company as a leader, while Sustainalytics rates it as high risk. How can it be? The most likely culprits revolve around methodology, structural bias, and data collection.

Throughout the industry, each rating agency uses a proprietary methodology. They all tend to use similar indicators but apply different methods. Structural bias can result from the reliance all systems have on company disclosures. This favors large companies with more resources and penalizes smaller corporations with limited resources. It all adds up to a low correlation (35.1% between MSCI and Sustainalytics) between the rating agencies.

“Sometimes the scores are awarded based on performance against peers, as is the case with MSCI, and other times, it’s an outright score, as with S&P Global’s CSAs,” Messervy notes. “This inconsistency, and the fact that most of the data is not audited or even reported by companies, requires further analysis before comparing scores across entities.”

What is a good ESG score?

A good ESG score is one that indicates that a company’s environmental, social and governance risks are very low. For MSCI, this would be an AA or AAA (Leader) rating. According to the Sustainalytics system, a score below 20 is probably considered good.

“Regardless of the scoring system or methodology used, users of such ESG data should remember that these scores are relative measures, meaning the ‘bar’ will and should rise continuously. Some investors will see relatively lower ESG scores of a company as an opportunity to engage with and influence that company to improve its ESG performance and extract Alpha, which should translate into greater long-term shareholder value.

Since each rating agency currently has its own system, investors should familiarize themselves with the systems they plan to consult when evaluating investments to determine which rating or score meets the following criteria:

Great: Indicates that the company follows best practices in all areas of ESG and has no (or very few) ESG issues.

Well: It means that a company complies with best practices in most ESG categories and has a relatively low negative impact on the environment.

Average: It suggests that the company is only partially compliant with best practices and is not actively working to achieve meaningful ESG goals.

Poor: It indicates that best practices are not being followed and that the company clearly has a negative impact on the environment and employees, and has not made any moves towards diversity in its governance structure.

The bottom line

It is important to remember that ESG scores are not the last word when it comes to evaluating investments. ESG scores are becoming increasingly important when it comes to weighing the risk posed by a company and its investments.

“Regardless of the scoring system or methodology used, users of such ESG data should remember that these scores are relative measures, meaning the ‘bar’ will and should be continually raised,” says Troy Mortimer, director ESG and Investment Manager at Alpha FMC, a global wealth and asset management consulting firm.

Since each rating agency has its own rating methodology, it pays to learn the methodology and choose a platform based on what you think is the best way to assess ESG risk.

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