As environmental, social and governance, or ESG, factors have become more prominent in investing, there has been a growing need to evaluate companies and investments based on their ESG compliance. These evaluations are produced by various organizations, and investors use them to guide their investment allocation decisions.
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Companies have also started to pay more attention to their own compliance, with many of them creating ESG scorecards to evaluate their own performance, independent of external appraisers. Given this growing importance of ESG investing, it is essential for investors to become familiar with how ESG scores are calculated. Here’s a breakdown of the different criteria that go into ESG evaluations and how they are applied:
— Types of ESG scores.
— Scoring methodology.
— Producers of ESG scores.
— Users of ESG scores.
Types of ESG Scores
ESG scores can be classified into three broad types depending on the issues that are being prioritized.
— Issue-specific ESG scores. These are ESG scores that measure the performance of companies and funds based on a single issue. An example is the water risk rating published by Institutional Shareholder Services.
— Category-specific ESG scores. Category-specific ESG scores go beyond one factor or issue, but all the factors they consider are within one single category: Environmental or social or governance. An example is the Carbon Disclosure Project, which focuses strictly on environmental issues. There is also the rating done by Kinder, Lydenberg and Domini, which strictly focuses on social issues.
— General ESG scores. These are ESG scores that focus on a variety of factors across all the three categories. Popular examples are MSCI ESG Ratings and Bloomberg ESG Ratings, among others.
Scoring Methodology
Every rating agency, irrespective of whether they are issue-specific, category-specific or general, uses a similar methodology.
First, the key issues that will be rated are clearly identified and defined. For example, MSCI considers about 37 key ESG issues as the basis for its rating. Other agencies have similar defined lists.
Second, the organization identifies the scope of the rating. For example, Bloomberg rates more than 10,000 publicly listed companies globally, while ISS ESG Ratings focuses on only 5,600 companies. Some agencies, such as FTSE Russell, define the scope of their work in terms of the number of securities rather than companies.
Third, the agency collects relevant information about the companies. These are the data they will use to rate and score the companies. Sources include publicly available information, companies’ ESG disclosures and private interviews with the management of those companies.
Fourth, companies are rated and scored on each of the rating factors previously identified.
Fifth, the scores on each rating factor are combined, with a defined weighting mechanism, to arrive at a final ESG score.
Finally, the agency provides a rating scheme by which ESG scores are categorized. For instance, the highest-scoring companies under MSCI ESG Ratings have an AAA score (Leader) while the worst-performing ones have a CCC score (Laggards).
Not all agencies go through this final process, however. S&P Global ESG Ratings and Sustainalytics only give scores between 0 and 100, without creating another rating scheme to categorize them.
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Producers of ESG Scores
Producers of ESG scores are varied, just as the types of ESG scores are. Nevertheless, we can categorize them based on the nature of their organization:
— NGOs. Carbon Disclosure Project is an example of an NGO that produces ESG scores.
— Financial services firms. Bloomberg, MSCI, FTSE Russell and S&P Global are examples of financial services firms that publish ESG scores.
Companies have also started producing ESG scorecards for themselves. They can then do a trend or horizontal analysis — comparing current performance with past performance. Companies can also evaluate performance in comparison to industry standards (where those data are available).
However, to avoid greenwashing — making erroneous claims regarding their ESG compliance and sustainability performance — companies must ensure they have an appropriate, objective framework on which to establish their ESG scorecard.
Examples of such objective and standardized frameworks include Sustainability Accounting Standards Board, Climate Disclosure Standards Board, Global Reporting Initiative, International Integrated Reporting Council and Principles for Responsible Investment, among others.
Whatever framework they use, companies must be consistent in their reporting. More importantly, they must set clear objectives and implement solid plans to meet (and even exceed) those objectives.
Users of ESG Scores
ESG scores allow investors to identify companies that align with their values.
If Investor A prioritizes environmental and climate issues, they can easily look at the ratings provided by the Carbon Disclosure Project to identify the companies that are big performers. On the other hand, if Investor B is concerned with environmental, social and governance factors, they can look at the ratings provided by Bloomberg ESG ratings, for example, and identify the big performers.
Two additional points remain. First, investors are better served using more than one ESG scoring platform. Using multiple platforms and comparing the performance of companies across the board can produce a more objective evaluation of the company’s ESG performance.
Second, for most investors, an ESG score is one factor among many (returns, dividends, etc., can be other important factors). Therefore, they must go back to their investment strategy and combine ESG scores with other relevant evaluative factors to make a more informed decision.
The ESG rating or scoring industry is still very young, and there have been calls for government agencies to streamline the rating system to ensure more transparency and standardization. It remains to be seen how things will develop in the future.
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ESG Investing 101: What Is an ESG Score? originally appeared on usnews.com
Update 05/22/23: This story was previously published at an earlier date and has been updated with new information.
