What are ESG ratings?

In a market where investors are demanding insight into companies’ sustainability credentials, ESG ratings can provide a means of measurement. But with a lack of consistency, opaque methodology and restricted source material, there isn’t a standout solution

Sustainability and ethical investing is coming to the fore even in the most traditional money markets, as proactive investing towards sustainable goals is seen to generate solid returns. Environmental, social and governance (ESG) criteria are being weighed to assess companies’ non-financial performance. When looking for long-term performance, longevity is clearly key, and investors are backing companies planning for a future where sustainability and ethical impact are central to survival.

These criteria cover a broad spectrum of issues, from environmental concerns such as contribution to climate change and resource management, to labour practices as well as product safety and data security – anything that might affect the sustainability of the business. The ESG lens offers a means of assessing the performance of a business beyond market value and financial performance. This arguably gives a more complete measure of strength and sustainability than financial analysis alone, by looking at areas previously unrepresented in investor forecasting.

The two are not mutually exclusive, of course. A study by Oxford University and Arabesque Partners shows a close correlation between consistently sustainable business practices and good economic performance. In 80% of the studies reviewed for the report, prudent sustainability practices were shown to have a positive influence on investment performance.

The aim of ESG ratings

The momentum behind ESG investing is undeniable. The sector was worth over $30trn globally in 2018, according to the Global Sustainable Investment Alliance, and is estimated to hit $50trn by 2040. It isn’t enough to invest in companies with a conscience, however. In order to achieve market-beating returns, an ESG-based ranking system is needed to sift the solid sustainability performers from the merely well-intentioned.

Investors could do their own homework, reviewing Ethisphere’s annual listing of the World’s Most Ethical Companies. Or comparing Fortune’s Change the World rankings. The Global 100 offers a compilation of the most sustainable companies around the globe. But all this is a lot of legwork in order to make informed investment decisions, and excludes thousands of companies which could still be a good ESG bet.

Enter ESG ratings. These offer a means for investors to rank companies against ESG criteria, to value performance on the sustainability scale. They draw on annual reports, media stories, the outcomes of shareholder meetings, data on executives, and investment analytics. Exposure to ESG risk and management metrics are examined. And from this data, a numeric score of a business’ financial risk, as related to specific ESG topics, is drawn. Ratings can also be broken down by issue and viewed granularly. The overall score is a proxy of ESG performance.

Generally speaking, the better the score achieved through ESG metrics, the more likely a business is to be able to weather long-term risk, engage in innovation and strategic thinking, and focus on long-term value creation. Investors believe attention paid to environmental, social and governance issues now will help build greater business resilience in the future.

ESG ratings can also be used internally, to benchmark a company’s success in achieving sustainability goals. They can highlight specific areas of weakness in relation to environmental, sustainability, and governance performance. The knowledge that they can also increase investment potential provides an incentive to take action on sustainability. And they provide an objective, external view of how the business is viewed by wider stakeholders.

Challenges within the ESG ratings market

To date, there isn’t a single, industry standard system to rate companies against ESG criteria. There are a number of ESG rating agencies, which provide clients with assessments of potential investments based on ESG performance. Major players include MSCI, Vigeo Eiris, Sustainalytics, and RobecoSAM. Each has its own method of calculating ESG scores and rankings, and these can vary widely, making it harder for investors to gain a clear understanding of a company’s ESG profile.

Consequently, there is no consistent quantification that can be used to assess ESG pedigree across the board. A further issue with the current state of play in ESG reporting is the source material being used to formulate ESG indexes. Data that is used to feed the scores typically come from voluntary company self-disclosure and mandatory company disclosures. This means that companies will effectively “mark their own work” and will provide some basic reporting on mandatory company disclosures. This leaves a whole range of external data out of the ESG ratings input.

Like corporate reputation, ESG ratings can be seen as at best subjective, and at worst intangible. And like corporate reputation, they require comprehensive datasets to analyse accurately the real ESG profile of the company. What is needed is an approach combining voluntary and mandatory disclosures with external datasets that help identify risks much better and provides a reliable comparison against the peer group. These datasets already exist, the difficulty lies in bringing them all together and maintaining them in real-time, rather than on a quarterly or annual basis.