ESG stands for Environmental, Social, and Governance. ESG investing refers to a set of standards for companies to consider when performing global and specific business decisions. For instance, criterions looked at by socially conscious investors are:
- Environmental: Investors consider how a company safeguards the environment. This section review includes the sourcing process, transformation, and sales. Particular attention is given to the policy set-up addressing climate change and how the company is processing the energy transition.
- Social: This review section deals with how the company promotes and manages its relationship with stakeholders such as employees (staff policy), suppliers (supply chain), customers (customer loyalty programs), and communities (marketing and the involvement of external agents). This is a non-exhaustive list.
- Governance: Corporate governance deals with a company’s leadership, executive pay, audits, compliance and compliance policies, internal controls, and shareholder rights.
In essence, the ESG aims to create an inventory of its processes and identifies the level of risk the company is undertaking. Particular focus is given to risky and unethical practices which should be addressed via mitigation strategies. The calculated ratio informs investors comparatively and simply about the reviewed entities’ relative ranking.
During the last few years, the number of investors who have shown interest in putting their money into ESG-compliant enterprises has constantly grown. According to an industry report from US SIF Foundation, investors held $17.1 trillion in assets chosen according to ESG principles in 2020, up from $12 trillion just two years earlier. ESG-specific mutual funds and ETFs also reached a record $400 billion in AUM in 2021, up 33% from the year before.
ESG Scores: The Basics
ESG scores are a measure of how well a company addresses risks and concerns related to environmental, social, and corporate governance issues in its day-to-day operations. These provide insight into a company’s long-term performance and resilience.
ESG scores can serve as a basis for comparing companies and funds across different factors. Ratio calculation may include the company’s carbon footprint and labor practices. Oftentimes, the calculated ratios have sector and activity bias, and therefore it is opportune to perform sector-specific comparative analyses. For the time being, there is no standardized valuation process, hence the lack of standardization can lead to variations in scores for the same company across different rating agencies.
An ESG score is a good starting point for educated investment decision-making. It is highly recommended to apply secondary and tertiary filters such as financial performance and industry trends, when making investment decisions. The leveled approach will ensure a well-rounded approach to evaluating potential investment opportunities.
How is the assessment done?
Environmental, social, and governance (ESG) scores are an easy tool to assess a company’s sustainability and ethical performance. These scores typically range from 0 to 100, with a score of less than 50 considered relatively poor and more than 70 considered good.
Key components, the main rating agencies use, include (non-exhaustive list):
Environmental Issues
- Carbon footprint
- Energy efficiency
- Renewal energy usage
- Energy transition engagement
- Water usage
- Pollution
- Waste management
- Biodiversity impact
Social Issues
- Labor practices
- Pro-diversity efforts
- Human rights
- Community relations
- Health and safety
Governance Issues
- Board diversity and structure
- Executive compensation
- Shareholder communications
- Risk management and risk mitigation strategies
- Supply chain management
- Supply chain diversity
- Business ethics
ESG Rating Agencies and Methodologies
Major banks and brokerage houses perform their own ESG analyses. Complementary, more than 250 well-established ESG rating agencies are covering developed market activities. While each agency has a unique methodology and set of criteria for evaluating companies, most of them express their findings with the use of a 0 – 100 scale. Only a few companies, like MSCI, classify entities as leaders, average, or laggards.
Private investors can access ESG scores for free. Yet, the available coverage is limited or linked to a trading account. Among the leader for free ESG rating are Yahoo!Finance, MSCI (very limited), CDP, or ESG ratings should be available in the corporate report itself, under the section sustainability. Oftentimes, the disadvantages of these free versions is that the information is compiled and assembled from different sources, and in-depth data, insights, and analysis are lacking.
Are there any limitations in the ESG Score?
Yes, there are multiple limitations. The most common are:
- Lack of standardization: There are different methodologies and criteria used by the various rating agencies.
- Greenwashing: To attract SRI-based investors, institutions may misrepresent or exaggerate their ESG efforts to improve the overall appreciation.
- Large-cap Bias: Larger companies are more difficult to assess than an entity in the small-mid cap section, which in absolute terms generates a distorted view. Large caps have their own ESG department which may communicate their own findings (biased probably) to third parties.
Base ESG Reporting Framework
For ESG scores to be calculated, companies must report and disclose relevant information and data. The Global Reporting Initiative (GRI) Standards are considered the most popular and widely adopted ESG reporting framework globally. Established in 1997, the GRI is an independent international organization that provides a comprehensive set of sustainability reporting guidelines for organizations of all sizes and sectors.
The popularity of the GRI Standards can be attributed to their flexibility, relevance across industries, and global recognition by various stakeholders, including investors, nongovernmental organizations (NGOs), and regulators. By adopting the GRI Standards, organizations can demonstrate their commitment to sustainability, identify and manage ESG risks, and communicate their progress to stakeholders.
Our take on ESG
ESG scores serve as a valuable tool for investors to assess companies’ environmental, social, and governance performance, enabling them to make informed, responsible investment decisions. By evaluating factors such as carbon footprint, energy efficiency, labor practices, and corporate governance, ESG scores provide insights into a company’s long-term sustainability and resilience.
However, due to the lack of standardization, potential for greenwashing, and other limitations, investors should consider ESG scores as one aspect of their investment decision-making process, rather than relying solely on them.
By using a combined approach, i.e., ESG scores plus top-down and bottom-up data and content analysis, investors are expected to better identify companies that align with their values and risk perception.