How are ESG ratings calculated?
ESG investing – also sometimes referred to as Ethical investing although they are not entirely the same– has quickly grown in popularity as more and more investors and pension savers aim to combine financial returns with making a positive impact on the world. ESG stands for Environmental, Social and Governance.
ESG investing is where fund managers invest in companies that work towards improving the Environment, addressing Social inequality or Governance improvements, so how a business operates.
But when it comes to ESG investing how can you ensure that you’re investing in the right companies and not being ‘green washed’? How ethical are the ethical companies you’re investing in?
One way to find ethical companies to invest in is to look at their ESG ratings. These are usually based upon a number of criteria, many of which may align with your own values and morals. While assessing non-financial performance, good ESG ratings can indicate that a company has strong staying power, through strong governance and is planning for the long term. As such, you can invest in companies that not only align with your values, but are more likely to have a long-term future too.
What is an ESG rating?
An ESG rating, or ESG score, is a measure of how a company is performing in terms of its environmental, social and governance responsibilities. These responsibilities might be material to the company, or of importance to the company’s stakeholders for reasons that aren’t financial. Company ESG scores exist so that both the organisation itself, as well as external bodies, can evaluate and understand how well the company is perceived to be performing. Companies that focus on ESG criteria often outperform companies that don’t.
It’s worth noting that there is a difference between perception and reality, and the ESG rating is calculated based only on how the company is perceived to be performing. A business might be putting some positive practices in place, but if this information isn’t in the public domain, it won’t make any difference to their ESG score.
ESG rating evaluations
There’s no one standard system for rating companies against ESG criteria. Rather, there are a number of different ESG rating agencies, and they all provide clients with assessments of investments based on the company’s ESG performance. Some of the biggest agencies include MSCI, RobecoSAM, Sustainalytics and Vigeo Eiris. All these agencies have different ways of coming up with company ESG scores – this can make it more difficult for investors to really know how well a company is performing. We explain each in a little more detail below.
MSCI ESG ratings are calculated by the use of a rules-based methodology, with companies – as well as countries, mutual funds, and ETFs – rated on a scale of AAA to CCC as per their exposure to ESG risks, as well as how well the company manages those risks compared to their counterparts.
Companies ranked AAA and AA are considered industry leaders, managing the most significant risks and opportunities, while companies ranked B and CCC are considered “laggard” based on their high exposure to ESG risks. In the middle are companies ranked A, BBB, and BB, who are considered to have an “unexceptional track record.”
Agencies measure 37 different issues around the environment, social concerns, and governance, including carbon emissions, electronic waste, privacy and data security, chemical safety, and tax transparency. Artificial intelligence, technology, and a team of over 200 analysts is used to calculate MSCI ESG ratings.
Robeco have developed a ‘Smart ESG’ methodology, as they argue that conventional methodologies don’t fit into traditional factor models and can result in biases towards regions or companies of a certain size. This is because larger companies will generally have better corporate sustainability processes, and European companies are generally more transparent. As a result, the Smart ESG methodology removes biases and combines past evidence with forward-looking views, using quantitative analysis. It’s used to test which sustainability indicators have had the strongest impact on past financial performance, with questions weighted so that the most relevant factors, materially speaking, are reflected in the score.
Sustainalytics’ ESG Risk Ratings measure the exposure of a company to industry-specific ESG risks, as well as how well the company is managing those risks, combining management and exposure to offer a comprehensive assessment of ESG risk.
There are five categories of severity: negligible, low, medium, high, and severe, and where a company falls is determined by a number of factors, from their business model and financial strength to their geography and incident history. They’ve created what they describe as a single currency for both ESG risk and the management of the risk, so that exposure and management scores for different issues can be combined – and compared – with each other. This better allows investors to compare the profiles of companies across their portfolio.
Vigeo Eiris scores companies from 0 to 100, analysing up to 38 different criteria framed within 40 industry-specific models. The 38 criteria span environment, social and governance, while they take into account the fact that different companies face different challenges, assigning each criteria with varying weights for each sector, from w0 – not relevant – to w3 – highly material. For each criterion, Vigeo Eiris looks at quality of leadership, extent of implementation and results. They begin by generating ESG criteria scores, and then move onto E-S-G scores, and then the ESG Overall Score.
Why invest in a company with a high ESG rating?
Companies with higher ESG ratings tend to be better at anticipating potential future risks and opportunities, more focused on value creation in the long term, and more adept at long-term strategic thinking. In short, if a company has a high ESG rating, it’s likely to place plenty of importance on long-term sustainability.
At the same time, part of the reason for investing in a company with a high ESG rating may simply be that you want to prioritise more ethical and sustainable companies, but reviewing ESG is becoming more widespread for financial reasons too.
As important as you might consider it to be to take ESG ratings into account, it isn’t always easy to keep track, since there’s no standard system for rating companies. With different ESG rating agencies using different methodologies, it can be difficult to know which companies are the best for you to invest in.
Encouragingly the regulators in the US, UK and continental Europe are considering reforming ESG disclosure rules so that investors can compare companies more effectively. With current data not standardised across all companies it can be hard to truly judge a company's performance against another.
If you’d like to learn more about ESG investing and how this approach may suit your own personal investment goals why not get in touch with one of our experts today for a free initial consultation.
Please note: Investment returns are not guaranteed and you may get back less than originally invested. Past performance is not a guide to future returns.