2023-08-02 12:00

ESG ratings: How to navigate the maze

As sustainable investing is growing rapidly and ESG performance is getting under closer scrutiny, investors and other stakeholders use third-party ESG ratings to compare various businesses. Unlike credit ratings, however, ESG ratings differ greatly depending on their provider and the methodology employed. Therefore, before embarking on a journey to get a desired ESG score, you should first look at the diverse evaluation mechanisms and understand what will be expected of you, depending on the ESG rating you will undergo.

ESG scores focus on risk

To begin with, a common misconception of ESG ratings is about what they reflect. ESG ratings primarily focus on a company’s exposure to material ESG-related risks and its ability to manage them. In short, ESG risks are factors that impact a company's financial success and management. Thus, ratings can help us identify companies that are financially stable in the long run and in the face of environmental, social and governance challenges.

ESG scores do not, however, necessarily measure the company’s impact (positive or negative) on the planet and society. For instance, MSCI, one of the leading ESG rating providers, focuses on assessing financially relevant ESG risks and opportunities.

That is not to say ESG ratings are not valuable tools. They reveal information not usually captured by traditional financial ratings. ESG ratings help interpret complex data and weigh multiple attributes by providing one comparable score at the end of the assessment process. Investors, asset managers, financial institutions and others can use ESG ratings to make informed decisions and understand risks and opportunities associated with a specific business. While stakeholders demand greater accountability and transparency from companies, ESG ratings can help businesses identify critical ESG areas where to focus their efforts to improve ESG performance, attract new talent looking for a socially responsible employer, support their public image, and improve sustainability communication.

Rating components and methodologies

As the name suggests, “ESG” ratings evaluate a company’s performance in three main dimensions – environmental, social and governance.

Under the environmental component, ratings analyse factors such as, e.g., implementation of environmental policies, measurement of carbon emissions, water use, waste management, biodiversity protection measures, etc.
Social responsibility falls under the social domain, which can encompass, e.g., workers’ rights, remuneration policies, health risks assessment, safety protection measures, diversity and inclusion, equal opportunities, etc.
Governance factors include e.g., board diversity, organisational structure, anti-corruption and bribery measures, whistleblower procedures, cybersecurity, etc.

These are only a few examples. Most ESG ratings consider tens or hundreds of criteria. Although the raters share the same objective – to provide insight into ESG quality – they have different methods for achieving their results.

Various criteria and methodologies

Generally speaking, the rating processes usually include the following key activities: materiality analysis, data harvesting and scoring.

First, it has to be determined which factors are relevant for the assessed company based on the sector and industry in which it operates, as well as its size, location and other relevant criteria.
Secondly, information is gathered from multiple resources. The main one is usually the company (internal policies, external reports, financial statements, codes of ethics, etc.). More can be learned from public databases, media or regulatory bodies. Missing information can be attributed using statistical models and educated guesses.
Lastly, final results are calculated, and rating scores are usually reported on a numeric or letter basis to mirror the company's absolute or relative ESG risk or performance.

Here we, however, encounter the main issue. ESG rating providers use their specific methodologies, mixing quantitative and qualitative analyses, all leading to a significant rating divergence.

The complex ecosystem of ESG ratings

A recent study by MIT Sloan researchers has identified three main drivers of ESG rating divergence – measurement, scope and weight. They found that the average correlation between the six ESG ratings is around 0.61. For comparison, they report a correlation between the leading credit ratings from Moody's and S&P of 0.99. Thus, the results of the credit assessments are many times more alike irrespective of their authors. ESG ratings, on the other hand, created for the same company by different providers can vary to a great extent. The study concludes that measurement divergence is the leading cause of this difference, as rating agencies use different indicators to measure the same attribute. The study demonstrated that the divergence is a matter of varying definitions and a fundamental difference in the underlying data used for analyses. Therefore, to address ESG rating divergence, one has to understand how the underlying data are generated.

Considering this, it is less surprising how different ESG rating providers can arrive at strikingly different results (e.g., in the case of Tesla). Further criticism of ESG ratings stems from greenwashing accusations because companies claim to perform well in ESG, presenting their ESG ratings without delivering any tangible results. You can read more on the fight against greenwashing in our article concerning the recent Green Claims Directive.

New EU ESG Ratings legislation

Since ESG ratings play a significant part in investment decision-making, ESG rating providers have become powerful institutions. MSCI, S&P Global ESG, ISS-ESG, Refinitiv, Sustainalytics, and EcoVadis are among the leading ratings. (We will write a separate article on the EcoVadis rating, stay tuned!)

The EU has recognised the need to address this challenge because of the plethora of ratings and the lack of clarity. There is a new regulation proposal on the table to improve the reliability and comparability of ESG ratings. The goal is not to consolidate methodologies but to increase transparency and integrity.

The main highlights of the proposal are:

Required authorisation of ESG rating providers by the European Securities and Markets Authority (ESMA) (incl. non-EU rating agencies);

Public disclosure of information on methodologies and their annual reviews;

To avoid potential conflicts of interest, ESG rating providers are not to be allowed to offer consulting services, credit ratings, investment activities, and such;

Possible exemptions for smaller rating providers.

All in all, ESG rating providers do not need to change how they calculate scores. However, they have to report on their methodologies in great detail. Considering the legislative procedure and the upcoming EU elections, the final Regulation will probably apply by early 2025.

What next? Get started on your ESG rating

Why do I need an ESG rating?

Despite being complicated, ESG ratings can help you assess your company’s readiness to face ESG challenges. First, you should be clear on why you want to undergo an ESG rating. Are you trying to attract investment? Do your supply chain partners demand it? Are you starting with ESG and hope to understand better where to focus your energy? Having a clear idea will help you effectively manage your expectations and make the best use of your results.

What is optimal for my company?

Other important areas to consider are the size of your company, the sector in which you operate, the resources you can invest in the rating preparations (not only in terms of financial resources but also knowledge, time and human capital), the current state of sustainability efforts in your company as well as ESG data available to you, to name a few. An ESG rating process is a complex procedure, and you will need the full support of your team and colleagues to gather all relevant information. Without having everyone on board, it can turn into a futile endeavour.

Is the methodology fit for our business?

When choosing a specific ESG rating provider, research the methodology they use, the areas they consider crucial, and the kind of documentation they will require. Some ratings, such as EcoVadis, are better suited to SMEs as they customise their questionnaires depending on a company’s size. If you have ever considered getting a certification like ISO, applying to SBTi, or joining the UN Global Compact, now would be a good time because such initiatives also play a part in ESG evaluations. Try to gather as much information as possible before submitting your application since the rating procedure usually has a specific time limit, and you do not want to get under unnecessary time pressure while searching for critical documents. Forewarned is forearmed.

Ready to get started? Do you want help with preparations? Contact us, and we will guide you through the ESG rating process.

Stay tuned for the upcoming article: ESG ratings - How to best prepare for an EcoVadis assessment?

Resources:

The secret life of ESG ratings | Greenbiz

How ESG ratings are built | Greenbiz

Are ESG ratings really necessary? | Greenbiz

ESG Ratings: A Compass without Direction

ESG Ratings and Corporate Sustainability Performance - A Primer

EU Regulation for ESG Ratings Providers - June 2023

ESG Ratings | Definition, Components, Agencies, and Methods

What is ESG Investing? MSCI Ratings Focus on Corporate Bottom Line

ESG Ratings: do they add value? How to get prepared?

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Lenka Havlenová