ESG Scores: The good, the bad, & why they matter
ESG scores: The good, the bad, & why they matter
Today's investors are beginning to look beyond the bottom line to understand company value and long-term sustainability. ESG (Environmental, Social, Governance) disclosure provides investors with a way to identify and understand key issues that aren’t typically accounted for on a traditional balance sheet yet have a critical impact on a company’s risks and opportunities.
Investors are increasingly adopting ESG, and it will continue to become embedded as a part of corporate strategies moving forward. As the market surrounding ESG expands, investors are demanding new tools to assess how companies perform from an ESG standpoint.
With an estimated $17 trillion in sustainable investment capital on the line, the stakes are high for companies and investors to make sound ESG decisions. To do this, institutions such as asset managers, pension funds, and endowments, often rely on ESG scores. But what exactly is an ESG score?
ESG scores in a nutshell
Simply explained, an ESG score is a measure of a company's exposure to long-term environmental, social, and governance risks that are often overlooked during traditional financial analyses. These risks include things like energy efficiency, worker safety, and board diversity, all of which can have significant financial consequences.
A strong ESG rating indicates that a company manages its ESG risks well in comparison to its peers, whereas a poor ESG rating indicates that the company has comparatively higher unmanaged ESG risk exposure. ESG evaluations and scores, when combined with financial analysis, can help investors gain a better understanding of a company's long-term potential.
Who calculates the ESG scores?
ESG rating agencies are third-party companies that specialize in ESG scoring. While there are hundreds of rating agencies that provide ESG scores, some of the prominent ESG score providers include Bloomberg ESG Data Services, Dow Jones Sustainability Index, MSCI ESG Research, Sustainalytics, Thomson Reuters ESG Research Data, S&P Global, ISS ESG, Vigeo/EIRIS, Fitch Ratings, and Moody’s Investors Service.
How is an ESG score calculated?
Each ESG rating firm has developed individual criteria for assessing ESG performance based on data gathered from a variety of sources, including securities filings, voluntary business disclosures, governmental databases, academic research, and media reports. Any ESG data that a business has made available through voluntary disclosure frameworks, such as the Global Reporting Initiative (GRI), the Value Reporting Foundation’s (VRF) SASB Standards, CDP, and the UN Sustainable Development Goals (SDGs), can serve as a significant source of data for most rating providers.
Using analysts and algorithms, the companies convert ESG metrics like a company's carbon emissions, board diversity, or safety procedures into siloed environmental, social, and governance scores, which are then merged into a single primary rating.
For example, MSCI examines hundreds of metrics and assigns a score of 0 to 10 to corporations on each important issue. These issues are weighted on their timeliness and probable impact. Issues with the greatest potential for impact (within two years) have the highest weights, whereas issues with less potential for impact and a timeline of five years or more have the lowest weights. In an industrial context, for example, worker safety poses an urgent risk with serious financial and legal ramifications, justifying a higher weighting. After assigning percentage weights to ESG risks, companies are compared to their peers and given a final rating.
Ultimately, companies are categorized by MSCI as leaders, average, or laggards.
- ESG leaders are proactively managing ESG risk and taking advantage of ESG opportunities better than their peers. Leaders have AAA or AA ratings.
- Average ESG performers may be managing some key issues well and others poorly, or they may be average across the board. Average ratings include A, BBB, and BB.
- Laggards have relatively more unmanaged exposure to ESG risk factors and receive ratings of B and CCC.
What do ESG scores measure?
ESG scores are based on environmental, social, and governance factors and assess issues such as energy use, employee satisfaction, business ethics standards, and executive pay.
Environmental issues include can include factors such as:
- Carbon emissions
- Climate change vulnerability
- Water sourcing
- Biodiversity & land use
- Toxic emissions & waste
- Packaging material & waste
- Electronic waste
Social scores include issues such as:
- Labor management
- Worker safety training
- Supply chain labor standards
- Product safety & quality
- Consumer financial protection
Governance issues can include:
- Composition of the board in terms of diversity & independence
- Executive compensation
- Accounting practices
- Business ethics
- Tax transparency
ESG rating companies also consider the opportunities within different ESG categories. For example, environmental opportunities can include clean technology, green building, and renewable energy while some social opportunities can be better access to communication, finance, or healthcare.
Ultimately, all of these risks and opportunities offer insights into the company that reveals a comprehensive picture of an organization’s environmental footprint and green initiatives, how much the company invests in the community, and how well they’ll hold up against relevant laws and regulations and any legal controversies.
What is a good ESG score?
Investors can compare a company's performance to that of industry peers and companies from other sectors by assigning an ESG score, which can range from 0-100. A score of less than 50 is regarded as poor, while a score of more than 70 is considered excellent.
Ratings can also be described as either excellent, good, average, or bad:
- An excellent ESG score indicates that best practices are being followed in all ESG areas and a company has little to no internal or external problems.
- A good ESG score signifies that a company is meeting best practices in each ESG category and has a low negative impact on people or the planet.
- An average ESG score indicates that companies are not on track to meet ESG benchmarks or actively working toward meaningful ESG goals.
- A poor score indicates that no best practices are being followed and are indicative of a company that is negatively impacting the environment and has employees who are being poorly treated.
Why do ESG scores matter?
Investors prefer companies with better overall ESG scores because they typically have fewer liabilities, making it easier to acquire capital and hire top talent. These companies also often have successful stakeholder relationships and a brand reputation. All of these factors have an impact on the profitability and bottom line of a business.
ESG scores allow investors to gauge the company's intentions actions—from how they treat their employees to how the board decisions are made or if environmental issues are being prioritized.
A high ESG score may persuade investors to invest in a firm, either because the company's values align with their own or because the company is sufficiently protected from future risks associated with issues like pollution or poor governance. An investor who is concerned about ESG may be turned off by a company with a low ESG score.
Companies with a low ESG score are thought to have the worst environmental, social, and governance impacts. Bad ESG scores have also been linked to rising poverty levels in the communities where the firm operates, as well as poor employee mental health.
What's the problem with ESG scores?
While ESG information can be useful when combined with other metrics, investors should not rely entirely on ESG scores to drive their investing decisions. The ESG score is not a reliable predictor of market success on its own, and there are numerous concerns with the existing lack of rules and transparency surrounding the criteria utilized for grading.
In the United States, for example, ESG disclosures aren't yet technically regulated, although the House of Representatives has introduced legislation requiring public businesses to provide ESG metrics on a quarterly and annual basis. Additionally, the Securities and Exchange Commission (SEC) recently proposed new disclosure rules surrounding issues such as climate risk and board diversity.
In the meantime, companies can use frameworks like the SASB Standards to guide disclosures in a variety of industries, but adoption is voluntary. Until there is global agreement on ESG frameworks and rating systems, ESG scores will only provide one piece of the ESG puzzle.
How to get started with ESG scoring
Your ESG ratings are only as good as your ESG data and disclosures, regardless of which third-party business evaluates a company's ESG score. Setting ESG targets, capturing key indicators and outcomes relevant to your industry, and ensuring this data is transparent and reliable are all good places to start.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.