ESG Scores Still Matter
ESG scores and ratings are similar concepts used to evaluate a company’s performance in environmental (E), social (S), and governance (G) factors. Scores are numerical values (like 1-10), while ratings are letter-based grades (like A-F). Both aim to assess a company’s overall ESG performance and its performance in specific areas.
A shift towards the low carbon economy is increasingly inducing investor behavior towards sustainability. According to a Bloomberg article, global ESG assets (such as ESG focused mutual funds, ESG EFTs and ESG integrated portfolios) exceeded $30 trillion in 2022 and are expected to surpass $40 trillion by 2030.The projected $40 trillion in ESG assets is expected to be over 25% of the total projected global assets under management (AUM) of $140 trillion, highlighting the increasing importance placed by investors on companies with greater ESG credentials.
Companies are increasingly facing various markets as well as regulatory pressures for ESG disclosure. Many stock exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq, exert pressure on companies to disclose ESG information by creating ESG indices, developing data platforms, partnering with rating agencies, setting listing requirements, and leveraging market incentives. Moreover, regulations such as European Union’s Corporate Sustainability Reporting Directive (CSRD) require large companies to disclose detailed information on their ESG performance. There has been a significant increase in the number of ESG services available, but regulations in places like the EU and UK are being introduced to improve the reliability and transparency of ESG data. And while the causal link between ESG performance and financial performance is still hotly debated, there exists a positive correlation between sustainability-focused investment and financial returns over the long-term.
Deconstructing ESG Scoring
Most ESG reports and ratings evaluate companies based on all three aspects of ESG: environmental, social, and governance. True ESG takes into consideration a company’s strategy, objective and business model. The evaluation criteria commonly include:
ESG scoring combination of quantitative data available in public records of a company and/or quantitative analysis conducted by analysts. The data is categorized under the three categories of E,S and G and scores are calculated based on performance under these separate categories, followed by overall scoring based at a company level. Below is simplified example of how ESG scoring works:
For instance, rating agency A prioritizes social factors the most, assigning them a weight of 60%, and environmental and governance factors are each given a weight of 20%. On the other hand, rating agency B assigns a weight of 60% to environmental factors, and 20% to social and governance factors. If a technology company scores 90 out of 100 on environmental factors, 50 on social factors, and 80 on governance factors, the final ESG score by rating agency A would be calculated as follows: (0.2 * 90) + (0.6 * 50) + (0.2 * 80) = 67, while rating agency B will scope the company as (0.6 * 90) + (0.2 * 50) + (0.2 * 80) = 80. This demonstrates how different weights of the three factors can significantly impact the overall ESG score.
The leading ESG rating providers are often well-known companies that already offer credit ratings, indexes, or analytics. ESG scoring and rating dependents on the agency that issues them. The methodology, scope and coverage varies across each agency. For example, Bloomberg and Corporate Knights rate companies on a 100-point scale, where a score of more than 70 is considered good. Some like Thomson Reuters assign a score between 0 (worst) and 1 (best) with an equivalent letter grade. Other rating agencies like MSCI (Morgan Stanley Capital International) use a 7-point scale (from AAA to CCC like major credit raters). Another example (ISS) includes those that use a 12-point scale from A+ to D-, akin to an education system.
A high ESG score suggests a company is committed to ESG and may have better financial performance and lower risks. A low ESG score could indicate a lack of interest or ability in addressing ESG issues. ESG scores are essential for socially responsible investing. Companies that want to remain competitive in today’s business environment should prioritize ESG.
Variations in ESG Scores and Ratings
The scoring criteria correlation between the major ESG ratings providers is demonstrated by this table from CFA (Chartered Financial Analyst) Institute.
| MSCI | S&P | Sustainalytics | CDP | ISS | Bloomberg | |
| MSCI | 35.7% | 35.1% | 16.3% | 33.0% | 37.4% | |
| S&P | 35.7% | 64.5% | 35.0% | 13.9% | 74.7% | |
| Sustainalytics | 35.1% | 64.5% | 29.3% | 21.7% | 58.4% | |
| CDP | 16.3% | 35.0% | 29.3% | 7.0% | 44.1% | |
| ISS | 33.0% | 13.9% | 21.7% | 7.0% | 21.3% | |
| Bloomberg | 37.4% | 74.4% | 58.4% | 44.1% | 21.3% |
Each cell in this table represents the correlation coefficient between two ESG rating providers. This correlation matrix reveals that S&P (Standard & Poor’s) and Bloomberg tend to have the most consistent ratings compared to other ESG providers. CDP’s (Carbon Disclosure Project) ratings appear less aligned with the broader market, while MSCI, Sustainalytics, and ISS (Institutional Shareholder Services) exhibit moderate levels of consistency. While there may be slight variations in the specific scores assigned by different providers, the overall consensus on which companies are considered more or less sustainable is relatively consistent.
Why do ESG scores matter?
ESG scores and ratings are used by various financial institutions. Institutional investors and asset managers like BlackRock and Vanguard use them to make investment or allocation decisions that align with their values and risk management goals. Banks and insurance companies such as Bank of America and SwissRe respectively, also consider these ratings for loaning, risk assessment and understanding their clients’ operations. Some lenders may offer incentives, like lower interest rates, to companies with strong ESG performance.
Issues regarding ESG Scores
There are several concerns about the use of ESG scores, including:
- Over-reliance on Internal Processes: ESG ratings often focus on a company’s internal processes rather than the actual environmental and social impact of its products and services. An example of this is Tesla’s recent criticism for its inclusion in some ESG indices despite allegations of workplace discrimination and safety concerns.
- Inconsistent Weighting: Different ESG data providers may assign different weights to individual ESG factors, leading to variations in scores and ratings.This has been discussed at greater length in the article above.
- Data Availability Bias: Larger companies, especially in emerging markets, may have more data available for ESG assessment, leading to potentially higher scores as explained by a study. For example, a large multinational corporation operating in India may have a significant advantage in ESG reporting compared to a smaller, locally owned company. The multinational might have access to global ESG standards, dedicated sustainability teams, and advanced data analytics tools. In contrast, the smaller Indian company may face challenges in understanding and complying with complex ESG regulations, obtaining reliable data, and allocating resources to sustainability initiatives. This disparity in data availability and reporting capabilities can lead to a bias in ESG ratings, potentially favoring the larger multinational company even if both companies have similar environmental and social impacts.
- Potential Biases in ESG Ratings: ESG ratings, while aiming for objectivity, can be influenced by various biases pointed out by the same study as in the point above. For example, large companies might receive lower ratings due to increased media scrutiny, as RepRisk suggests. Conversely, ESMA (European Securities and Markets Authority) points out a bias favoring large companies, as they can actively engage with rating providers to improve their ESG perception, leading to higher average scores.
For more insights and guidance on navigating the evolving landscape of ESG scoring, sustainable investing and other related issues, stay tuned to our blog for future updates and expert analyses.
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