Companies receive ESG scores and ratings from agencies that gauge their performance on Environmental, Social, and Governance metrics. Those scores and ratings are used by asset managers and investors to understand the ESG risks companies face and the impact of their actions on the external environment.
Of late, there has been much discussion about the ESG rating ecosystem. Since this ecosystem is much more recent compared to the credit rating mechanism, there are concerns about transparency, conflict of interest, and rating bias, among other things.
Here’s a list of the popular ESG rating agencies: ISS ESG (by Institutional Shareholder Services); Moody’s; MSCI; S&P Global; Sustainalytics (a Morningstar division); Bloomberg ESG scores; Fitch Climate Vulnerability Scores; FTSE Russell’s ESG Ratings; CDP’s climate change, forests, and water security scores.
In this article, we explore the 10 things organizations must know about ESG scores and ratings and how the agencies responsible for such assessments function.
1. Standardized ESG Reporting Methodologies Help ESG Scores
Companies must use sustainability accounting standards to make their ESG disclosures to help ESG rating agencies make an effective assessment of their ESG performance. While there are multiple sustainability standards to choose from, companies must make use of the standard mandated in their specific geographic area. For instance, large companies in the UK are required to use the Task Force on Climate-Related Financial Disclosures (TCFD) framework; and companies in the EU are set to use the final version of the European Sustainability Reporting Standards (ESRS). The framework being developed by the International Sustainability Standards Board (ISSB) is expected to be widely used across geographies for corporate sustainability disclosures.
2. Digital ESG Reporting Can Enhance Transparency and ESG Scores
Several sustainability accounting standards have digital taxonomies that enable companies to make digital ESG disclosures. The format driving digital ESG reporting is XBRL or eXtensible Business Reporting Language. Using software tools, companies can place machine-readable XBRL tags or codes against their sustainability disclosures so that their reports become digitally accessible and readable. The starting point for digital ESG reporting is the XBRL taxonomy versions of popular sustainability standards. Efforts are underway to create such digital standards. In the EU, the European Financial Reporting Advisory Group (EFRAG) is in the process of creating the XBRL version of the European Sustainability Reporting Standards (ESRS). The International Sustainability Standards Board (ISSB) has released a draft XBRL taxonomy of its ESG framework.
3. Industry-specific Disclosures Help Gauge ESG Performance Right
For effectively measuring ESG credentials, companies’ performance must be judged on industry-specific metrics. The rule applies to both ESG reports and ratings. The ESG reporting standards introduced by the Sustainability Accounting Standards Board (SASB) is a case in point – it supports 77 industries. MSCI, the rating agency, gauges sustainability performance based on 35 of the most relevant issues specific to each industry. Industry-specific measurement takes into account the differences in input material, wastage, and output of each industry in terms of their specific impact on the external environment and society. Companies must identify the set of standards specific to their industry before starting out with ESG disclosures.
4. ESG Scores Can Help Even Out ESG Performance across Metrics
In early 2022, the S&P ESG 500 Index dropped Tesla Inc, the electric vehicle manufacturer, citing, among other things, the lack of an internal strategy to report and reduce carbon emissions and poor handling of an investigation into deaths and injuries caused by Tesla’s autopilot vehicles. Interestingly, other indices did not drop the company. The point to be noted is that ESG ratings assess companies on E, S, and G factors and act as a leveller of their performance on each metric. A company with a positive environmental record cannot expect to automatically score well on social and corporate governance issues. Each issue will be weighed separately and receive a distinct score that adds up to the final rating.
5. ESG Scores and Weights are Combined to Derive a Numerical Rank
Here’s an example of how ESG scores and ratings are derived. MSCI weighs key ESG issues based on timeline and impact. For instance, if an issue is poised to have a major environmental or social impact within two years, that issue would account for a higher weight. Issues with a timeline of over five years and lesser expected impact will have a lower weight. The scores and weights of each issue are combined to derive an industry-adjusted score between 0 and 10 for a company. Since rating methodologies differ by agency, companies would do well to adhere closely to sustainability reporting standards and adopt XBRL reporting to keep their disclosures accessible and transparent. It can also help to understand how different rating methodologies work.
6. ESG Ratings Suffer Due to Poor Data Gathering Mechanisms
Some rating agencies rely on data that is in the public domain, while others send questionnaires or forms to receive information that companies do not otherwise make public. The biggest challenge, however, is the lack of a steady stream of ESG information. Moreover, the proliferation of rating providers working with different methodologies is forcing asset managers to pool in data from multiple providers before making their decisions. Some asset managers are said to have developed their own internal rating system. Another problem area is that much of the available information is about the risks companies face from external factors. There is a need for more data on how companies are impacting the environment and society. The remedy for this is ESG reporting that factors in the double-materiality principle.
7. There is Scope for Divergence in The ESG Ratings Provided
In a recent study called Aggregate Confusion: The Divergence of ESG Ratings, a group of researchers used data from six prominent rating agencies to show how organizations can end up receiving different ratings from different agencies for the same set of ESG performance data. The researchers mapped data from the six agencies to a common taxonomy to identify three areas of rating divergences – Scope, Measurement, and Weight. They could also identify a phenomenon called the “rater effect”, where companies with a positive public perception receive better ESG scores than those companies with a generally negative perception. The researchers concluded that while the measurement of ESG performance is not a futile exercise, it poses a challenge where the underlying data and the use of ratings and metrics need careful consideration in each specific case.
8. There Are Calls for Regulating the ESG Ratings Ecosystem
Several regulatory agencies and global bodies have recently raised concerns about the risks associated with the ESG rating ecosystem and called for greater regulation. Prominent among these are the European Securities and Markets Authority (ESMA), the UK’s Financial Conduct Authority (FCA), and the International Organization of Securities Commissions (IOSCO). An ESMA report pointed out that the absence of a consensus on what constitutes ESG risk gave rating agencies the room to independently decide on the definitions – which was affecting the comparability of ESG ratings. IOSCO said there were concerns about conflicts of interest where rating agencies provide consulting services to the companies whose rating assessments they undertake. The UK’s FCA, meanwhile, hinted at the idea of bringing rating and data providers under its purview.
9. ESG Scores Cannot be The Sole Indicator of Sustainability Efforts
Investors who care about sustainability and impact would do well to not take ESG scores as the sole indicator of companies’ ESG performance. This is partly because of the lack of standardized methodologies to gauge ESG performance. However, this has also to do with the need for investors to do their own due diligence before committing their resources to a cause. Read companies’ sustainability reports and listen to what NGOs, civil society, and employees have to say about them. That’s because the rating ecosystem – at least for now – does not allow investors or other stakeholders the certainty of an unbiased view of any given organization’s sustainability credentials.
10. ESG Rating Agencies Can Fall Short of Their Stated Purpose
ESG ratings and the agencies that offer them can fall short of their stated purpose – Russian companies are a case in point. Sberbank, a lender backed by the Kremlin, was already subject to international sanctions before Russian troops entered Ukraine. However, the bank had a higher rating than some of its Western counterparts, and, in fact, received an improved rating from two popular rating agencies in December 2021. Once the Ukraine offensive began, the rating agencies were quick to reverse the ratings of Sberbank and other Russian lenders, citing their exposure to fresh Western sanctions. The move has come in for severe criticism from various quarters and calls for a revision in the way geopolitics and human rights issues are factored into a sustainability rating.