Sustainability isn’t just good for the planet; it’s necessary for all business owners. Investors, legislators, and consumers are all factoring environmental, social, and governance (ESG) scores into their decision-making. If your score doesn't measure up, greener manufacturers might outcompete you.
The good news is that companies of all sizes can implement measures to improve their ESG ratings, reaping the benefits of sustainability practices almost immediately. But first, you need to understand how these scores are calculated and which factors influence your rating most.
What Is an ESG Score?
An ESG score is a snapshot of a company’s performance in mitigating environmental, social, and governance risks. Various factors, such as contribution to climate change, energy efficiency, waste management and disposal, employee safety, and preservation of human rights, determine the scores.
Investors can learn a lot about the liability exposure of a business from its ESG ratings. For example, a company with a dedicated energy efficiency program is less likely to suffer delays when a new law requires mandatory upgrades. The fewer liabilities a business has, the more stable and resistant to losses it becomes.
Although sustainability topics haven’t historically been factored into financial analysis, they are increasingly shown to impact a company’s worth significantly. As a result, investors often combine financial analysis and ESG ratings to evaluate a company's long-term prospects.
Why Is a Company's ESG Score Important?
Investors use ESG to calculate a company’s overall risk. Higher ESG scores suggest better risk management and a more diversified approach to problems than comparable businesses, making them more attractive to analysts and venture capitalists.
In contrast, low ESG ratings might cause investors to question:
- Product quality - Lax waste management practices might give investors the impression that the company doesn’t uphold the highest standards in its products or services.
- The scope of their investment - Investors might raise interest rates or offer short-term loans based on their impression of the company’s long-term profitability.
- Their own exposure - Investors concerned with their own reputation or liability are unlikely to align themselves with a company with a poor ESG score.
- Employee quality of life - Low ESG ratings have also been linked to deteriorating employee mental well-being and rising poverty rates within the organization.
How Are ESG Scores Used?
ESG scores can be used in many different ways. These ratings are public, so the applications are limitless depending on who interprets the data. Some common uses for ESG ratings include:
- Funding. High rankings on environmental and social considerations make businesses more attractive to financial institutions, giving them more competitive funding options.
- Hiring top talent. Higher ESG scores make it easier to attract executives and skilled workers who prioritize environmental health.
- Peer comparison. ESG scores allow organizations to compare their ratings and track their position in the industry.
- Benchmarking. Companies can use their vendors’ ESG scores to determine which companies they should align with to strengthen their supply chain.
- Measuring progress. A company’s first ESG score can be used as a baseline to compare the effects of new procedures and environmental initiatives.
- Marketing campaigns. Posting an ESG score on your company’s social media can attract new customers, strengthen your brand reputation, and allow you to expand into new markets.
Which Agency Assigns ESG Scores?
There are hundreds of third-party agencies that calculate ESG scores. These entities collect information from diverse sources, including corporate filings, external databases, and news articles, to evaluate a company's ESG practices and policies. Some of the most popular ESG scoring firms include:
- MSCI - The MSCI score is among the most common ESG assessment providers, scoring over 8,000 corporations and over half a million global fixed-income and equity instruments.
- ISS ESG - Institutional Shareholder Services (ISS) offers insights into the financial material data found within typically non-financial ESG disclosures.
- Sustainalytics - This company’s ESG Risk Ratings help investors detect ESG risks in over 12,000 businesses.
- Refinitiv - Refinitiv uses publicly reported data to calculate ESG scores for worldwide companies.
- Thomson Reuters - Thomson Reuters has assigned ESG scores to over 6,000 global firms.
- RepRisk - RepRisk uses artificial intelligence to compile and sort ESG scores for private and public businesses.
- Bloomberg - Bloomberg ESG Data Services uses data from MSCI, Sustainalytics, and its own sources to score businesses in more than 100 countries.
- Fitch Ratings - Fitch Ratings uses a proprietary scoring system to link an ESG score to credit ratings.
- DJSI - The Dow Jones Sustainability Indices selects the top 10% of sustainable companies across 61 industries.
What Factors Influence an ESG Score?
Each ESG element has a unique set of standards. Environmental elements consider a company's environmental impact and protocols to mitigate adverse effects. Anything that affects the social environment of a company, such as the demographics, pay, and rights of its workers, is a social element. Senior management, tax practices, and shareholder rights all fall under governance.
An ESG scoring model considers factors in the following categories:
- Waste byproducts
- Carbon emissions
- Climate policies
- Land use
- Natural resource use
- Water sourcing
- Toxic waste or hazardous emissions
- Packaging materials
- Waste disposal
- Reuse and recycling initiatives
- Consumer protections
- Product quality
- Employee safety training
- Employee satisfaction
- Population vulnerability
- Local demographics
- Labor management
- Supply chain labor practices
- Consumer financial protection
- Profit sharing
- Community engagement
- Accounting methods
- Board and CEO diversity
- Business ethics
- Pay equity
- Executive compensation
- Tax transparency
How Are ESG Scores Calculated?
Each rating agency uses its own methodologies and criteria to review companies and assign ESG ratings. For example, MSCI identifies each company's key issues and risks within the context of its industry and uses a rule-based methodology to create an ESG rating. The S&P Global Corporate Sustainability Assessment uses industry-specific data from survey questions. At the same time, the Sustainalytics score is based on a company’s unmanaged ESG risk.
In general, the steps of ESG rating calculation include:
The process's first step is gathering information on an organization's ESG efforts. It's like piecing together a puzzle to understand their performance regarding environmental, sustainability, social, and governance practices. Data can be collected from a variety of sources. Some of it is readily available to the public, like news articles and academic research. Specific ESG reporting frameworks, such as GRI or TCFD, provide guidelines for gathering this data.
Sometimes, the data is collected through direct interviews and analysis with the company itself. This approach can be more qualitative in nature, as it relies on information obtained from surveys and other sources. On the other hand, a quantitative approach relies on publicly available information that the company has released in accordance with international standards. This method looks at complex numbers and data points.
Most rating providers use any ESG data that a company has willingly shared, such as data from frameworks like the Global Reporting Initiative (GRI), the Value Reporting Foundation's (VRF) SASB Standards, CDP, and the UN Sustainable Development Goals (SDGs).
During analysis, the scoring agency considers a wide range of data points related to ESG issues and decides how important each piece of information is. MSCI, for instance, uses a scale from 0 to 10 to rate each issue, considering how relevant and impactful it is likely to be. Agencies also assign weights to these issues depending on the potential impact each one might have over the next two years. Issues with a higher potential for impact get heavier weights in the overall assessment, giving more importance to the things that can make a more significant difference in the near future.
ESG rating companies also consider the opportunities within various ESG categories. It's not just about identifying risks; it's also about recognizing the potential for growth and improvement. For instance, environmental opportunities might involve clean technology, green building projects, or renewable energy initiatives. On the social front, opportunities could include improving communication, finance, or healthcare access.
Once percentage weights are assigned to assess ESG risks, the next step is to compare how companies perform relative to others in the same industry. This comparison helps arrive at a final rating, which considers both the risks and the opportunities.
What Is a Good ESG Score?
An ESG score is given as a number ranging from 0-100. Poor performance is generally defined as a score of less than 50, while any score over 70 is considered excellent.ESG scores are categorized as follows:
- Excellent: A firm with an excellent rating operates according to ESG best practices and has a very low internal and external liability risk.
- Good: A corporation with a good ESG rating strives for ESG best practices and has a low rate of adverse environmental or social effects.
- Mediocre: Reviewers give a mediocre rating to companies underperforming on important ESG objectives or to companies whose ESG interventions still need to meet the standard
- Poor: A poor rating indicates that no best practices are followed and the company negatively influences the environment and its employees.
Scoring also varies based on the agency giving the assessment. For instance, MSCI ESG ratings include the following:
- Leader companies have letter ratings of AA to AAA and scores ranging from 5.714 to 10.000.
- Average companies have letter ratings of BB, BBB, or A and scores ranging from 2.857 to 5.713.
- Laggard companies have a letter rating of CCC or B and scores of less than 2.856.
Problems With ESG Scores
ESG ratings are a valuable assessment tool. However, it's important to note that these ratings have limitations. There are several underlying problems with the way ESG scores are calculated and reported, including:
Lack of Standardization
Scores can vary widely since no universal framework or standard for calculating ESG ratings exists. As a result, it can be difficult for a company to tell which factors could raise or lower their rating.
Data Quality and Reliability
ESG data can be inconsistent, incomplete, or unreliable. Some companies may keep critical ESG information private, making it difficult to assess their true performance accurately.
ESG scoring involves subjective judgments and interpretations. Rating agencies may have differing opinions on the significance of certain ESG factors, leading to score variations.
ESG data may be outdated, causing a lag in reflecting a company's current ESG practices and performance.
Some companies may engage in "greenwashing," which involves overstating or misrepresenting their ESG efforts to improve their scores and reputation without implementing substantial changes in their practices.
Due to limited resources and data availability, many small and privately held companies may not be assessed by ESG rating agencies leading to incomplete assessments.
Focus on Reporting Rather Than Impact
ESG scores often rely heavily on self-reported data from companies. High scores can sometimes result from strong reporting practices rather than tangible positive impacts on the environment, society, or governance.
Some ESG scores may emphasize short-term performance or immediate financial impacts, potentially overlooking long-term sustainability concerns.
Incomplete Coverage of All ESG Factors
ESG scores may not comprehensively cover all relevant ESG factors, potentially omitting critical issues that are material to specific industries or regions.
The proliferation of different ESG rating agencies and methodologies can confuse investors, who may struggle to make informed investment decisions based on varying ESG scores.
ESG scores often rely heavily on self-reported data, which may not capture the full picture of a company's ESG practices, especially regarding qualitative aspects or cultural elements.
Limited Regulatory Oversight
There needs to be more consistent regulatory oversight and standards for ESG reporting and scoring, making it challenging to ensure accuracy and accountability.
Few reporting agencies willingly reveal how they calculate their scores, giving little insight into why different vendors assign different scores to a company.
Lack of Industry-Specific Metrics
ESG scores may not adequately account for industry-specific nuances and challenges, making it challenging to make meaningful comparisons between companies in different sectors.
Ethical and Moral Concerns
Some critics argue that reducing complex ethical and social considerations to numeric scores can oversimplify and commodify important ethical and moral issues.
ESG scores aim to compare a company's performance to its competitors. They can be misinterpreted if compared to businesses in different industries.