Given the growth of environmental, social, and governance (ESG) strategies over the last 10 years, investors are increasingly interested in finding ways to evaluate companies based on their ESG scores. There is also concern about companies’ exposure to certain environmental, social, and governance risk factors.
As a result, several third-party scoring agencies have emerged to aggregate and analyze ESG data, and put it into a form investors can use.
The need for outside ESG scoring services stems from the fact that, for now, ESG guidelines are in flux. Some are voluntary, some are mandatory, and some companies have developed proprietary scoring systems to measure their performance, compliance, and risk mitigation in light of ESG standards.
In short, in most cases investors cannot turn to a single type of ESG score, but must become familiar with how different ESG scores work and how they’re applied.
Key Points
• Investors interested in ESG investing strategies need ESG scoring systems to evaluate companies.
• Investors are also aware of the ESG risk factors some businesses face and want evidence of risk mitigation.
• Because ESG standards vary, and companies adhere to different guidelines, hundreds of third-party scoring agencies have emerged.
• Most ESG scores are composite measures of how well a company is meeting certain standards.
• Investors need to know how a score is calculated in order to fully understand whether it’s assessing a company in a relevant way.
What Is an ESG Score?
An ESG score consists of aggregated measures of a company’s environmental, social, and governance data, as it pertains to that company’s operations, production, supply chain, workforce, corporate leadership, and more. These ESG metrics can include factors such as:
• Greenhouse gas emissions
• Renewable energy use
• Pollution mitigation
• Worker safety
• Fair labor practices
• Executive compensation
• Transparency in accounting and security
Although not a part of traditional financial metrics or fundamental analysis, these factors can have a significant impact on a company’s financial performance. If companies put out ESG reports on an annual basis, investors can see how they compare to competitors and whether or not they are making improvements over time to meet ESG goals and mitigate risks.
Currently, in the ESG investing sector there are challenges involved in adopting ESG standards and reporting models. ESG frameworks and metrics can vary by sector, company size, and geographic location. In addition, some are required while others are voluntary. Some proposed regulations have been met with legal challenges. More details on that below.
Examples of ESG Scoring Systems
There are three broad categories of ESG scoring methods.
• General. These ratings focus on a range of environmental, social, and governance factors.
• Issue-centric. Issue-focused ESG scores measure the performance of companies based on a single issue like renewable energy use, carbon emissions, or labor standards.
• Category-specific. Category-specific ESG scores drill down into one of the ESG pillars (environmental, social, or governance). For example, a ratings company might assess companies only along governance lines.
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What Do ESG Scores Measure?
Just as there isn’t one set of ESG standards that all companies must adhere to, there are also different types of ESG scores. Each ESG score is meant to summarize information that investors and stakeholders committed to green investing can use for decision-making.
Some capture a company’s compliance to external (or proprietary) ESG rules. Some evaluate how much progress a company is making toward certain standards. Others may assess the risk levels a company faces from various environmental, social, and governance factors.
When taken pillar by pillar, ESG scores may include the following:
Environmental:
• Carbon emissions
• Climate change risks and planning
• Water use
• Biodiversity
• Land use
• Energy efficiency
• Toxic emissions & waste
• Packaging material & waste
• Electronic waste
Social:
• Labor management
• Worker safety
• Labor standards (e.g. diversity)
• Product safety & quality
• Consumer relations
• Community relations
Governance:
• Composition of the board
• Executive compensation
• Accounting practices and transparency
• Business ethics
• Corruption
• Cybersecurity
Other Factors to Consider
There can also be other factors within each of the three categories, which rating agencies may take into account when calculating an overall ESG score: e.g., sourcing of environmentally sustainable materials for product development, or addressing ESG risks in the supply chain can come into play.
Ideally, an ESG score helps to flesh out investors’ understanding of companies’ performance, risks, goals, and opportunities. Equally important for investors, an ESG score can provide a way to compare companies more accurately.
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Which Agencies Calculate ESG Scores?
Some 600 third-party agencies now conduct ESG data gathering, analysis, and scoring. As noted, some agencies specialize in a single ESG pillar, while others do all three.
Some of the most well-known rating agencies include Bloomberg ESG Data Services, Dow Jones Sustainability Index, MSCI ESG Research, Morningstar Sustainalytics, S&P Global, ISS ESG, Moody’s Investors Service, and Thomson Reuters ESG Research Data.
How Are ESG Scores Calculated?
These days, many companies are required to submit ESG disclosures along with their standard annual or quarterly reports. There are inconsistencies here as well — e.g., the SEC’s attempt to require certain types of ESG disclosures in 2024 was challenged in court, and is currently on hold.
But companies that comply with disclosure rules need to adopt reliable ESG frameworks that include specific standards and metrics. ESG frameworks help standardize the criteria employed in ESG disclosures, which serves stakeholders across the board. One of the most common is the Global Reporting Initiative (GRI), a set of voluntary standards that has nonetheless been adopted by 80% of large corporations.
Variations in ESG Scores
Every ESG scoring agency has its own methods for analyzing and reporting performance. Some agencies look at internal data such as voluntary disclosures and reporting, while others look at publicly available data.
Some agencies weigh ESG metrics based on their potential impact. For instance, worker safety may have a higher weight in an overall score because it poses significant financial and legal risks within a short-term time frame for that organization.
The ratings also take into account how the company compares to others in its industry. Some ratings agencies have different scoring frameworks for different industries, weighing factors based on their importance to that industry.
ESG Score Example
The MSCI ESG score is a widely used ESG rating system for thousands of equity and fixed-income companies worldwide. MSCI defines issues that are relevant to specific industries (e.g., carbon emissions may apply more to manufacturers than to banks), and looks at dozens of exposure metrics (which rate a company’s exposure to, say, biohazards or supply chain risks), as well as nearly 300 governance metrics.
Companies are then given a score from 0 to 10, with lower scores indicating that the company may not be mitigating that risk, and higher scores demonstrating a more proactive strategy around risk mitigation.
Those scores are then weighted according to complex, industry specific criteria. MSCI then translates the weighted scores into ratings that range from CCC to AAA.
What Is a Good ESG Score?
It’s important to understand the difference between ESG rating agencies and what metrics they focus on, since there isn’t a global standard for ESG scores. Investors can look at the ESG scores of different companies as part of their comparison prior to or after investing.
Some ESG scores range from 0-100, with 0 being the worst and 100 the best. Sometimes scores also have letter ratings between CCC and AAA.
Score ranges may be categorized as poor, average, good, or excellent. Companies may also be referred to as laggards, average, or leaders.
How Investors Can Use ESG Scores
Investors can look at ESG scores to compare companies they are interested in investing in or are already invested in. A high or rising ESG score may be a good indicator of lower ESG risk.
However, ESG scores shouldn’t be the only thing an investor looks at when making decisions about sustainable investing. There are not many regulations or standards around ESG reporting and ratings, and not all ESG data is of high quality. There can be issues with transparency and a lack of information about how data is collected and analyzed.
Key ways investors can use ESG scores are:
• As a supplement to traditional financial analysis.
• As a tool to evaluate potential risks and opportunities.
• To find companies that match one’s personal values.
• To evaluate improvements or performance decreases in existing investments.
The Takeaway
Looking at company ESG scores is a useful way to evaluate potential investments in addition to traditional financial metrics. Environmental, social, and governance scores can help identify potential risks as well as investment opportunities. As interest in sustainability continues to increase — as well as the concerns about how ESG risk factors may impact business performance — the accuracy, availability, and transparency of ESG scores is likely to keep improving.
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