More Data, More Transparency: Why Are ESG Ratings important?

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by KnowESG
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Financial markets are currently not factoring in the full costs associated with sustainable business practices. Issues such as the effects of having an unsatisfied workforce, the security of a company's data, and their susceptibility to climate change are not fully considered in traditional financial analysis. However, these factors are increasingly being acknowledged as having a significant financial impact.

More often, investors are using ESG criteria as the starting point to evaluate the long-term success potential of their portfolios, based on non-financial factors such as environmental impact, social responsibility, and ethical governance. ESG is a responsible investment approach that measures the sustainability and ethical impact of a company according to these three factors.

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What are ESG criteria?

ESG criteria can help investors consider environmental, social, and governance factors that may not be measured or represented in traditional financial analysis. This data, therefore, provides insight into a company's sustainability beyond just financial performance, and into often unconsidered areas of company operations that, when fully explored, may provide benefits in terms of resource savings, workforce productivity, and leaner management, all of which may ultimately prove to be financially profitable. 

ESG criteria have proven to be highly valuable as ESG portfolios consistently outperform traditional portfolios. Oxford University and Arabesque reviewed over 200 sources on ESG performance and found that sustainability-focused companies experienced operational performance improvements in the majority (88%) of cases, resulting in higher cash flows. A meta-analysis of more than 2000 studies confirmed that ESG investment has tangible benefits for both responsible and economic reasons.

In recent years, there has been a significant increase in ESG investments, which have become popular in the markets. In Europe, sustainable and responsible investment strategies received a remarkable commitment of 49% of total assets in 2018. This percentage saw an upward trend of 11% from 2016 to 2018, and it's expected that the trend will continue.

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What are ESG ratings or scores?

An ESG score measures how effectively a company manages risks related to environmental, social, and governance issues in its everyday activities. This encompasses issues such as climate change adaptation, energy efficiency, employee health and wellbeing, diversity, equity, and inclusion (DEI), and human rights. Although these topics used to be overlooked, ESG reporting and case studies have demonstrated their substantial impact on a company's profitability in addition to the obvious sustainability advantages.

If a company has a strong ESG rating, it means they manage its ESG risks better compared to its competitors. On the other hand, a poor ESG rating means the company has higher unmanaged ESG risk exposure compared to others. Combining ESG ratings with financial analysis can assist investors in understanding a company's long-term potential for sustainable growth.

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Why are ESG Ratings important?

Due to the increasing importance of ESG criteria, as well as the emergence of mandatory reporting in some regions, investors now have access to an impartial method to evaluate a company's ESG performance. Various ESG rating agencies such as Sustainalytics, MSCI, and FTSE ESG cater to this need, assessing the ESG performance of companies worldwide and providing their clients with access to this information.

The purpose of ESG ratings is to assist investors in identifying and comprehending financially significant ESG risks associated with a company. The ratings are based on publicly available information such as media sources and annual reports, and they assign scores for each material 'E', 'S', and 'G' topic, as well as an overall score. 

Investors use the special scores to judge a company's ESG performance. If a company scores well, it is thought to be better at predicting future risks and opportunities, more likely to think long-term, and focused on creating long-term value. While mandatory reporting is emerging, the ratings system provides the critical tool with which companies can choose to make the shift to a culture of growing transparency, helping to identify gaps and opportunities for sustainable growth models that will deliver more robust development in the mid- to longer-term. 

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How are ESG ratings calculated?

ESG rating firms use their own algorithms and criteria to calculate scores, resulting in different scores for the same company. They gather data from sources such as securities filings, voluntary business disclosures, governmental databases, academic research, and media reports to evaluate ESG performance.

ESG data voluntarily disclosed by a business through frameworks like Global Reporting Initiative (GRI), Value Reporting Foundation’s (VRF) SASB Standards, CDP, and UN Sustainable Development Goals (SDGs) can be used as important data by rating providers. The data is categorised into environmental, social, and governance scores, which are then combined into a single primary rating.

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The companies use analysts and algorithms to transform ESG metrics, such as a company's carbon emissions, board diversity, or safety procedures, into separate environmental, social, and governance scores. These scores are combined into one overall rating.

For example, MSCI evaluates numerous metrics and gives companies a score ranging from 0 to 10 for each significant issue, based on the issue's timeliness and potential impact. Issues with high potential impact within two years have higher weights, while those with a low impact and a timeline of five years or more have lower weights. After assigning percentage weights to ESG risks, companies are compared to their peers to determine a final rating.

MSCI categorises companies as either leaders, average performers, or laggards.

  • Leaders: Companies with AAA or AA ratings who proactively manage ESG risks and seize ESG opportunities are considered as ESG leaders, which sets them apart from their peers.

  • Average Performers: Some companies that are rated in terms of their ESG performance may excel in specific areas but fall short in others while others might have an overall average rating such as A, BBB, or BB.

  • Laggards: Investors should be aware that companies with ratings of B and CCC may have higher levels of unmanaged exposure to ESG risk factors compared to other companies. This group of companies is often referred to as Laggards.

How companies can use ratings

Investors are now considering ESG scores in their investment strategies. If your company receives a poor rating from an ESG data provider, investors may consider your stock to be an 'unsustainable asset' and exclude it from their investment portfolio. If several investors follow this approach, it could eventually lead to a drop in your stock price.

To attract investment in Europe, for example, your company must understand and improve its ESG scores, as nearly 50% of assets are managed with responsible investment criteria. It is essential to acknowledge that ratings serve as a useful tool for internal benchmarking, guiding decision-making and enhancing sustainability performance. An external evaluation of your company's ESG performance by an expert provides an objective assessment of performance and its comparison with competitors and peers. It can be a compelling motivation to take measures towards increasing sustainability performance.

Additionally, the assessment can be a reliable source of information to advocate for change, by identifying specific areas that need improvement. 

Takeaway

ESG ratings are not consistent between providers, and this discrepancy in scores is seen as a major drawback. The same company may receive vastly different ratings from different providers. To address this issue, some argue that standardisation of methodology is needed across the industry to ensure objectivity and credibility.

Remember that ESG scores aim to measure intangible and difficult-to-measure aspects. Therefore, it is important to have realistic expectations of these scores. They provide only a starting point and an indicator, but not the complete story.

Based on our experience, it can be highly beneficial to examine the individual scores for each aspect of E, S, and G, as well as their subcategories. This examination can provide insight into a company's perceived strengths and weaknesses regarding their sustainability approach and initiatives, and also help position them relative to their industry peers. The abundance of information within each ESG pillar can then be used strategically to guide a company's strategy and reporting, resulting in higher ESG scores and overall sustainability performance.

The Bottom Line

Yes, the ratings system is in an early stage of development, and the fact there are many ratings providers only underlines the differing needs of each sector or specific business. There is no single, coherent framework, and there likely will never be. However, this diversity of approaches to quantifying ESG performance shows the diversity in tools required in the global transition to sustainability. 

That shift, the move away from ‘traditional’, extractive and acquisitive models of short-termist business growth, to be replaced by models of sustainability and regenerative use of resources, is the biggest challenge of our time. Transparency is critical for us to measure progress, and ESG ratings are the tools that provide it.

KnowESG collects ESG ratings performance data, as well as published sustainability reports, on a growing number of companies. Use our Company ESG Profiles to easily compare ESG performance across sectors.

Frequently Asked Questions (FAQs)

Who uses ESG Ratings?

ESG ratings are used by various parties such as investors, regulators, consumers, and employees. Investors, in particular, are progressively relying on ESG ratings to guide their investment choices and evaluate the companies they invest in for long-term sustainability.

How are ESG Ratings calculated?

Typically, ESG ratings are determined by a blend of quantitative and qualitative data taken from diverse sources such as financial statements, sustainability reports, news articles, and other relevant sources. Based on this assessment, ratings agencies ascertain a company's ESG performance and assign a rating accordingly.

What are some examples of ESG issues?

The term "ESG issues" refers to a broad range of topics such as climate change, environmental impact, human rights, labour practices, diversity and inclusion, executive compensation, and others. Rating agencies may prioritise different issues based on their focus areas and methodology.

How can companies improve their ESG performance?

Companies have multiple options to enhance their ESG performance. They can establish concrete sustainability objectives and targets, introduce robust governance mechanisms, involve stakeholders, lessen their environmental impact, and ameliorate their social influence. Companies must pinpoint areas where they can deliver the most significant results and take specific measures to enhance their ESG performance.

Track published ESG ratings, together with reports, on thousands of companies here.

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