Choosing an investment based on ESG standards can take time and effort. That’s because there is no unique ESG scoring system for all companies – each rating agency measures each company according to its own standards.
In this article, we take a look at what constitutes an ESG score, some of the top ESG rating agencies, and the inherent issues we still face when using these metrics to measure a company’s true risks and opportunities in terms of environmentsocial and administrative norms.
Key learning points
- ESG scores are not standardized. Individual rating agencies calculate them, so they vary wildly.
- ESG scores are usually assigned a numerical value of 1-100 or 1-10. Some agencies also use a letter grading system.
- ESG scores are relative, meaning that if a company outperforms its peers in the same industry, it can have a high ESG score without being particularly beneficial to the environment or substantial diversity, equality, and inclusion initiatives ( DEI) to include.
What is an ESG score?
ESG scores rate companies according to three categories that relate to the company’s business opportunities and risks. Those categories are environmental (E), social (S) and governance (G).
ESG scores from most agencies range from 1 – 100. The higher the number, the better the score. Some agencies use other grade scales. For example, one of the largest rating agencies, MSCI, uses a scale of 1 to 10.
Some rating agencies then categorize each company in terms of letter ratings, with AAA being the best and CCC being the worst.
How are ESG scores calculated?
The factors associated with each ESG score and how they are weighted vary by rating agency. This is extremely important to remember as not every agency will weigh metrics based on your investment values. You may need to shop around to find the rating agency that best suits your investment philosophy.
For example, if you’re primarily interested in companies with clean energy initiatives, look into a rating agency’s system to make sure it ranks that high in its score.
In general, however, here are some factors that rating agencies consider when calculating ESG scores.
Metrics used to establish an environmental score can vary from agency to agency. For example, MSCI ESG scores typically consider the following:
- Climate Change: This may include the the company’s ecological footprint and efforts to reduce or offset carbon emissions.
- Natural capital: This category looks at companies’ use of natural resources, such as water resources, raw material procurement, and efforts to support biodiversity through land use.
- Pollution and waste: In this category, MSCI looks at electronic and toxic waste and how a company handles packaging materials. In May 2022, the S&P 500 ESG Index kicked Tesla off for violations of the EPA’s Clean Air Act and California’s waste handling.
- Environmental Opportunities: Environmental issues are not just an area for constraints or risks; they can also be an opportunity for simultaneous economic growth. Things like green building practices, renewable energy and clean technology can attract new investors looking to tomorrow’s economy.
Social statistics see how well the company manages its stakeholder relationships. This may include paying employees fair wages, a company’s impact on the communities in which it operates, and holding business partners in the supply chain accountable to standards similar to those the company sets itself.
For example, to produce cashmere sweaters, retailers need to work with farmers in places like Mongolia as well as with weavers in other countries. Many cashmere producers now clarify on their website that they work with outside organizations to ensure farmers’ welfare and fair wages. An ESG rating agency may look for such certifications to evaluate a company’s social metrics.
Corporate governance is the third category and includes the principles of diversity, equity and inclusion (DEI), business ethics, executive compensation and tax transparency, among others.
For example, a company with a board composed of both men and women—particularly if those men and women come from different racial and ethnic backgrounds—is likely to score higher on board metrics than a board composed mostly or entirely of white men.
Another crucial aspect of the governance category is lobbying and political contributions. If a company invests in political parties that push legislation that is considered environmentally harmful or socially regressive, it is more likely to score lower. As a result, it is not surprising that ESG investing has become another battlefield for a culture war – more on that below.
What is a good ESG score?
When agencies calculate ESG scores in numbers, they can fall into the poor, average, good, or excellent category. For rating agencies using a scale of 1 to 100, the levels are as follows:
- Excellent: A score of more than 70.
- Good: A score between 60 and 69.
- Average: A score between 50 and 59.
Once they calculate the ESG score, the rating agency can assign a grade according to a letter system. While MSCI is not the only agency that reviews ESG investments, they are one of the largest. Here’s how they implement the lettering system:
- AAA or AA: These letter designations represent companies that are leaders in ESG standards.
- A, BBB or BB: These letter designations represent companies that match the industry average in meeting or setting ESG standards.
- B or CCC: These companies must comply with industry standards regarding ESG standards.
Who calculates ESG scores and how do I find one that meets my investment goals?
MSCI is a rating agency that deals with ESG investing, but there are others. Here are some of the largest agencies that release ESG ratings and examples of investors whose ratings are best for them.
- Extended: MSCI, S&P Global and Sustainalytics all weigh fairly equally on environmental, social and governance issues. Still, significant differences exist between each agency’s rating system.
- Environment: If you’re primarily concerned about climate change, you can turn to assessments from the Carbon Disclosure Project (CDP). Companies can only get a CDP rating if they respond to a survey requested by a shareholder. As a shareholder you can submit such a request.
- Management: Institutional Shareholder Services (ISS) Governance QualityScores rank companies according to the governance portion of ESG standards.
Potential issues with ESG scores
ESG scores are not standardized across rating agencies. As we discussed, three of the largest comprehensive ESG rating agencies – MSCI, S&P Global and Sustainalytics – have significant differences between their corporate ratings, even though they measure across similar domains.
ESG scores can sometimes be misleading. You may be surprised to learn that ExxonMobil – one of the world’s largest oil and gas companies – is on the S&P 500 ESG Index. There are a number of reasons for this.
The first is that ESG scores measure companies against others in their industry. Because Exxon ranks well compared to other oil and gas companies, it made it onto the list.
Another is that companies like Exxon can strive to appear carbon neutral, not necessarily by reducing emissions, but by pledging to reduce emissions in the future or buying carbon offsets.
Also, ESG rating agencies usually measure direct carbon emissions when assessing the carbon footprint. This means that the agency does not account for emissions from the use of a company’s products. Under this policy, a company like Tesla gets insufficient credit for its low-emission products, while a company like ExxonMobil can get away with relatively environmentally harmful products.
For an example of inconsistencies between rating agencies, you can see that ExxonMobil gets a D rating of InfluenceMap despite being included in the S&P 500 ESG Index.
In these ways, companies can manipulate ESG ratings. They seem more environmentally or socially responsible than they are because they are doing better than others in an already troubled industry.
Recent backlash against ESG investing
ESG investing has become part of a recent culture war waged primarily by Republican legislators. The arguments vary, but mostly focus on private investment groups that focus more on appearing socially conscious rather than making a profit for their investors. Conservative politicians have also argued that investing in ESG-friendly companies is a betrayal of investor values.
Earlier this year, conservative lawmakers in Kansas and Indiana dropped anti-ESG legislation because representatives of the two states’ pension systems opposed it. In both cases, the pension system expected billions of dollars in losses over the next decade if the state government passed anti-ESG legislation.
There is valid criticism of the rules for assigning ESG scores and the lack of standardization between agencies. However, whether the widespread conservative criticism of ESG investing is entirely bona fide is questionable.
It seems inevitable that with a population becoming increasingly involved combat climate change and in support of progressive social issues, investors will look for an opportunity to invest in companies that support similar causes. The ability to do this is a natural feature of a free market.
It comes down to
You probably come into contact with ESG investing with noble intentions. But be prepared, measuring a company’s impact, risk and growth potential is tricky. There are no standard, agreed-upon metrics for evaluating a company’s ESG efforts. Even if they were, the rating agency’s values may not be consistent with your values as an investor.
That doesn’t mean ESG investing isn’t worth pursuing. You can research each rating agency’s stats to decide which best aligns with your values. You can also look into groups such as hedge funds that focus on investing in ESG companies.
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