As investors seek to evaluate companies beyond their financial performance, environmental, social, and governance (ESG) issues have gained prominence in financial markets. ESG disclosures offer insight into crucial factors not captured in traditional balance sheets, including information on long-term sustainability impacts. In this context, investors are seeking additional, complimentary tools such as ESG scores to assess corporate performance and identify risks.
But what are ESG scores? Who produces them? And how do they shape sustainable investment decisions?
What are ESG scores?
According to the Corporate Governance Institute, “an ESG score is a measurable statement of impact, grading success and challenges within the vast field that is environmental, social and governance.” Often used interchangeably with ESG ratings, ESG scores provide a snapshot of how effectively a company addresses ESG risks in its everyday operations. These risks encompass areas like climate change adaptation, diversity, equity & inclusion (DEI), energy efficiency, human rights, and so on.
Typically, ESG scores consist of an assigned quantitative metric, such as a letter rating or numerical score from 0-100, to capture a company’s overarching ESG performance and risk exposure. While a high ESG score reflects strong proficiency in managing ESG risks, a lower score signals higher exposure to unmanaged ones. Nonetheless, scores are impacted by other key variables including peer performance, macro industry trends, and changes to the scoring platform’s proprietary methodologies. Thus, investors will tend to take other aspects of a company’s performance into account, including the quality and transparency of its disclosures, before making final allocation decisions.
A note on peer performance—while certain organizations, such as the CDP, evaluate both the company’s performance and its performance relative to others in its industry, not all firms do so. Thus, the consideration of peer performance will depend on the ESG score provider in question and their proprietary methodology.
By combining ESG evaluations and scores with financial analysis, investors can gain a comprehensive understanding of a company's potential for significant and sustainable growth, into the future.
“An ESG score is a measurable statement of impact, grading success and challenges within the vast field that is environmental, social and governance.”
- Corporate Governance Institute
What do ESG scores measure?
While ESG scores reflect environmental (E), social (S), and governance (G) issues (and how well they’re managed), what goes into the score won’t be the same for every company. This is where the concept of materiality or “material issues” comes into play.
Materiality refers to business conduct-related issues that are important and relevant to a particular industry or company. This includes specific activities that the company undertakes, where it is located, and where it operates. Stakeholders care about material issues and will make decisions based on how well companies manage them.
While some ESG aspects are more central to particular industries, many are more universal or far-reaching, such as emissions, labor practices, business ethics, and so on.
Let’s look at the major components of an ESG score:
- Environmental performance focuses on an organization’s impact on the natural world, such as its energy consumption, waste management, water conservation, and carbon emissions. Assessing the “E” can involve the following questions:
- Does the company implement robust environmental policies and practices?
- Has it reduced its carbon emissions by 25% compared to industry benchmarks?
- Does the company actively promote recycling within its operations?
- Does the company invest in renewable energy sources?
- Social performance includes areas like diversity and inclusion, human rights, Indigenous reconciliation, and health and safety. Assessing the “S” can encompass the following questions:
- Does the company prioritize employee welfare and fair labor practices?
- Does the company provide competitive wages and benefits?
- Does the company ensure a safe working environment for its employees?
- Does the company actively support social initiatives in local communities?
- Does it maintain transparent communication with stakeholders, fostering accountability and addressing social concerns?
- Governance performance pertains to corporate leadership, executive pay, board composition, business ethics, bribery, and corruption, to name a few. According to the World Economic Forum, governance is a foundational ESG pillar, setting the stage for effectively addressing both environmental and social performance. Assessing the “G” can involve the following questions:
- Does the company follow transparent governance practices, with a clear board structure and effective oversight mechanisms?
- Does the company maintain a high level of integrity and ethical conduct throughout its operations?
- Does the company ensure compliance with relevant regulations and industry standards?
- Does the company maintain comprehensive disclosure practices, providing accurate and timely information to shareholders and investors?
Why do ESG scores matter?
Far from a passing trend, ESG scoring is here to stay. According to the Harvard Law School Forum on Corporate Governance, “most international and domestic public (and many private) companies are being evaluated and rated on their environmental, social and governance (ESG) performance by various third-party providers of reports and ratings.” In turn, ESG scores are used by institutional investors, asset managers, financial institutions, and other stakeholders to assess and measure a company's ESG performance and risk exposure— relative to its peers. Moreover, these assessments frequently prompt investors to engage with companies, both informally and through shareholder proposals, on ESG-related issues.
According to MSCI, investors utilize ESG ratings for various purposes, including fundamental or quantitative analysis, constructing portfolios and managing risks, engaging with companies and promoting thought leadership, and benchmarking and creating index-based products.
With capital allocations—and brand reputation—increasingly on the line, companies are realizing the inextricable link between disclosure quality and ESG scoring. But it can be difficult to accurately identify, analyze and report on material risks and opportunities. Luckily, with the use of ESG data management software, the ability to measure and assess performance along multiple ESG metrics is becoming less burdensome.
Where do ESG ratings, questionnaires, and research-based ratings fit into this?
There’s often confusion surrounding the terms ESG ratings, questionnaires, and research-based ratings—but are they all the same?
They aren’t. While not all ratings use questionnaires, all questionnaires lead to a particular rating or ESG score.
But what are third-party questionnaires?
Third-party questionnaires are essentially “ESG surveys” to obtain information on a company’s holistic ESG performance, generated through a specific ESG score. Moreover, they’re voluntary and rely on proprietary methodologies. To date, the two most popular questionnaire-based ratings are CDP and S&P Global, but there are others to keep an eye on: UN Global Compact Communication on Progress, EcoVadis, B-Corp.
In contrast, ESG research reports are created by research firms. They rely solely on publicly accessible information, which can include: an annual report or proxy statement, published policy documents, sustainability disclosures, etc. The most popular research-based ratings are those of MSCI, Sustainalytics, and Moody’s (formerly Vigeo Eiris). It’s important to keep in mind that these firms can generate an ESG rating without your input; should this occur, it’s important to understand what was assessed, and how. Although proprietary methodologies tend to lack transparency, you can learn a lot from reading your company’s research report, and, when possible, your peers’.
ESG scores—are there different types?
There are different ways to think about and “classify” ESG scores, with differing opinions regarding the best way to do so. For the Corporate Finance Institute, ESG scoring systems tend to fall under two main categories: industry-specific ESG scores vs. industry-agnostic ESG scores. While the former focuses on issues that are material to the wider industry, industry-agnostic ESG scores generally encompass more universally meaningful metrics—think DEI, climate change, human rights, etc.
Broadly, ESG scores can also be categorized into three main areas:
- General ESG scores: These scores reflect practices and activities across the entire spectrum of ESG performance. For instance, general ESG scores include MSCI ESG Ratings and Bloomberg ESG Ratings. The latter generates proprietary scores that enable investors to evaluate company or government disclosures and performance across various ESG and thematic issues. Subsequently, these scores can be integrated into company research and portfolio construction processes, providing valuable insights for investors. It’s important to note that general ESG scores also reflect category-specific and issue-specific ESG scores.
- Category-specific ESG scores: This type of score goes beyond one factor or issue, but all the factors they consider fall within a single category: environmental, social, or governance. For instance, the Carbon Disclosure Project (CDP) focuses strictly on climate-related issues.
- Issue-specific ESG scores: These scores assess the performance of companies and funds with a narrow focus on a single issue. For instance, Institutional Shareholder Services (ISS) issues a water risk rating that concentrates exclusively on evaluating a company's water-related risks.
Who produces ESG scores?
ESG scores are produced by various entities, including well-known third-party rating agencies such as ISS, one of the world's largest institutional investor advisory services. Below, we present a general categorization of the different ESG score providers:
- Non-governmental organizations: The CDP is an example of a not-for-profit charity that provides ESG scores, with a special focus on environmental issues. CDP is renowned for its rigorous approach, conducting primary research directly with issuers instead of relying solely on organizations' voluntary disclosures.
- Financial services firms: A number of financial service firms have entered the ESG scoring arena. Prominent examples include Bloomberg, Sustainalytics, MSCI, FTSE Russell, and S&P Global. These firms provide ESG scores to meet the demands of investors seeking ESG-related information.
- Company ESG scorecards: Recognizing the significance of ESG performance, numerous companies have begun developing their own ESG scorecards, allowing them assess to their compliance and performance trends over time. To maintain credibility and avoid greenwashing, companies must construct their ESG scorecards using objective frameworks such as the Sustainability Accounting Standards Board (SASB),Climate Disclosure Standards Board (CDSB),Global Reporting Initiative (GRI),International Integrated Reporting Council (IIRC), and Principles for Responsible Investment (PRI).
Among the above ESG score providers, it’s important to understand that their report and rating methodologies, as well as their scope and coverage, differ significantly. While some providers actively seek input and engagement with the companies they assess, which allows for data improvement or correction, others do not initiate contact with the subject company.
ESG scoring challenges—what are they?
While ESG scores play an important role in evaluating companies' environmental, social, and governance performance, the ESG ratings industry is still relatively young. Some of the most common challenges include:
- Lack of standardization: One of the major hurdles in ESG scoring revolves around the absence of uniform methodologies and criteria. Various rating agencies and frameworks employ diverse approaches, which can result in disparities and make it challenging to draw comparisons between companies based on their scores. For instance, McKinsey reports that, while S&P and Moody's credit scores correlate at 99 percent, the six most prominent ESG score providers correlate (on average) by only 54 percent.
- Data quality and reliability: While ESG scores mainly rely on company data, this data tends to vary in terms of accuracy and quality. And, because companies have different reporting practices and levels of ESG maturity, obtaining comparable and reliable data is an ongoing challenge for most. Overall, these differences can make ESG scores less reliable and useful for investors.
- Limited scope and coverage: When it comes to ESG scores, publicly traded companies tend to occupy center stage, thereby excluding smaller or private companies. Also, it's common to see particular sectors or industries receiving more scrutiny and attention than others, which can introduce evaluation gaps or potential biases. It's therefore worth considering both the depth and breadth of coverage when interpreting ESG scores.
- Greenwashing and data manipulation: Greenwashing pertains to the practice of making unsubstantiated or misleading claims about a company's ESG performance. Certain companies may strategically present themselves as more sustainable or socially responsible than they are in reality, which can negatively impact their public image, and, in some cases, even lead to litigation. Thus, ESG scores that are based on exaggerated or false data are misleading to investors who rely on them to make decisions. Ultimately, mitigating greenwashing and manipulation concerns requires companies to ensure that their ESG data is accurate, reliable, and audit-ready.
- Evolving regulatory landscape: The dynamic landscape of ESG reporting standards is being shaped by the introduction of new regulations and shifting trends in the corporate sustainability space. This presents a formidable challenge for companies and rating agencies alike, as they must swiftly adapt to regulations that are, in the view of some, becoming more complex and comprehensive by the minute. Therefore, to gain a deeper understanding of ESG scores, it's imperative for investors to remain well-informed about these ongoing developments.
Calls have been made for government agencies to play a role in streamlining the ESG rating system to ensure consistency, transparency, and comparability across different ratings agencies. For example, in March 2023, the UK government initiated a consultation to review the regulation of ESG ratings providers, and is exploring the possibility of bringing them under the oversight of the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). The government’s consultation paper outlines their plans for the new regulations, with the goal of “improving the transparency of methodologies, governance, and processes of ESG rating providers” to prevent misleading information that could impact investors. The regulations would apply to providers offering assessments to users in the UK for specific investments, subject to certain exclusions.
Get started with ESG scoring
For the foreseeable future, ESG scores are expected to remain integral to the sustainability reporting and finance landscape. When companies comprehend and utilize them effectively, these ratings offer valuable insights for enhancing disclosures.
To improve your ESG ratings, it's essential to establish clear ESG targets, collect relevant indicators and outcomes specific to your industry, and ensure that this data is both transparent and accurate. These steps form a solid foundation for enhancing your overall ESG performance.
Novisto simplifies ESG data management and voluntary reporting for forward-thinking organizations. Designed for the real world, the platform’s settings and customized report builder are aligned with renowned third-party questionnaires including the S&P and CDP. We also provide you with dedicated support and advisory services throughout your sustainability journey, ensuring that your data is robust and investor-ready.
Unlock the value of your ESG data by requesting a free demo of Novisto.
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