4min read
Published on: Jul 12, 2024
#Financial Markets
“We found that ESG was almost universally top of mind for these executives.”
Key Takeaways
As sustainability and climate change concerns rise, ESG ratings are essential in boardrooms. They are now a key metric for decision-making by both issuers and investors. A recent HBR study involving leaders from 43 global institutional investing firms, including the top three asset management firms, found that ESG factors are a priority for these leaders. In the paper, the team noted:
"We found that ESG was almost universally top of mind for these executives."
Knowing a company's ESG rating is essential for guiding the business correctly, attracting investment, and improving transparency with shareholders. This article discusses ESG ratings, how they are calculated, their impact on investment decisions, and more.
ESG ratings evaluate an organisation’s environmental, social, and governance practices. These ratings assess how well a company manages its environmental impact, relationships with employees, clients, and suppliers, and overall corporate governance.
Different providers may approach ESG ratings differently. Many focus on risk, while others, like Inrate, emphasise impact. This approach is based on Double Materiality, which looks at the influence of the environment and society on a company (risk) and the company's influence on the environment and society (impact). Inrate believes focusing on impact is more beneficial for promoting sustainability.
Image: ESG meaning
In summary, ESG ratings encompass the following:
ESG ratings provide a comprehensive view of a company's sustainability performance by considering both risk and impact. They aid investors and issuers, including asset managers, pension funds, and individual investors, in making informed decisions. They believe firms with high ESG scores are more effective at identifying and mitigating risks and capturing opportunities in an increasingly complex and volatile business and legal environment. Such companies are considered to be more likely to generate better results in the future.
Related Read: ESG Investing Explained
ESG ratings enable the development of sustainable financial products, assess potential risks and opportunities of portfolios, incorporate extra-financial information for financial analysts, and help fund providers recognise innovative companies.
Customers and investors are more likely to invest in companies with good governing and environmental standards, and employees also want to work for such companies. ESG ratings can help involved parties in many ways. Below are some of them.
As social issues like inequality, human rights, and climate change become essential, investors and stakeholders demand that companies become more sustainable and responsible. ESG ratings are used to evaluate a company’s performance in these areas so that stakeholders can determine how sustainable and ethical the company is.
There is a rising trend of investors seeking to invest in companies that share their values and provide long-term returns. ESG ratings assist investors in determining which companies are likely to perform better in the future through effective ESG risk and opportunity management. This is especially true for investors concerned with environmental and social responsibility investments.
They can help investors understand risk and return and compare a company to others in the industry. Thus, implementing ESG factors into investment processes can help investors manage risks in today’s shaky financial landscape.
ESG ratings act as a reference point and assist in identifying investment opportunities. They help asset managers identify and implement sustainable and ethical investments, which improve performance in the long run. ESG ratings also help prevent legal and reputational risks resulting from poor ESG practices and enhance relations with clients and employees.
The rating provides a systematic approach to disclosing ESG factors, improving companies’ responsibility and openness by allowing stakeholders and investors to know a company's ethics. ESG ratings also help companies report more information about their performance, enabling stakeholders to pressure them to comply with and follow ESG principles.
The ratings competition pushes companies to enhance their sustainable and ethical standards, implement the best practices, generate ideas for improving society and the environment, and engage stakeholders to build a better world. As companies seek to outperform their competitors, the entire industry experiences a boost.
Below are some of the challenges around ESG scoring.
Over-Reliance on Ratings | ESG ratings are often considered sustainable; however, they are based on a review of the company's internal procedures and do not entirely reflect the actual effects the product or service has on the world. |
Variability in Scoring | The problem with the ESG data is that different providers may assign quite different scores to the same company, which hinders a clear picture. |
Data Biases | These are mainly the larger organisations, particularly in the developed markets. They usually get higher scores because they have better data, while the smaller firms and those in the developing markets may score poorly. |
Conflicts of Interest | ESG index providers who are also in the business of providing ratings may assign higher scores to firms that have better stock returns, which creates a conflict of interest. |
However, it’s worth noting that different ESG ratings can give contrasting pictures of the same company. This shows that better rating approaches are needed. A recent 2021 CFA Institute report pointed out that businesses with multiple variations in ESG scores have higher risk premiums and better stock returns.
Shareholders are pushing for better quality and standardisation of ESG information reporting from companies with the help of regulators. Most investors nowadays perform their own ESG rating, sometimes even with the help of AI to collect and analyse the data.
A score that indicates low ESG risks is considered to be good. This is relative to the agency for which one takes the test since different agencies take different tests. For example, Bloomberg and Corporate Knights work on a 100-point system, where anything above 70 is considered good.
Thomson Reuters uses a 0 to 1 scale with letter grades, and RepRisk uses a 0 to 100 index and AAA, AA, A, BBB, BB, B, CCC, CC, C, and D ratings.
Some ESG ratings and reports are freely accessible to the public. For instance, the DJSI releases global and regional sustainable indices for better-performing companies. Every year, Bloomberg and RepRisk ratings are usually for investors but can be used in the investment process. Some organisations allow companies to check the data used in calculating ESG scores and provide suggestions on how to increase ESG performance.
Today, ESG ratings are crucial in forming investment strategies. These scores are becoming popular among investors, as ESG-oriented portfolios tend to perform better than conventional ones.
Frontiers’ study shows that more investors are attracted to firms that incorporate ESG into their business operations. This can help attract more funds, increase financial performance, and enrich product offerings. This is backed by a meta-analysis of more than 1,000 papers that show the real return on investment of ESG investing.
On the other hand, firms that receive poor ESG ratings may be labelled as ‘unsustainable assets’ and be sold out by the investors. If many investors subscribe to this view, it will cause the company’s stock price to nosedive. Thus, it becomes critical to understand and enhance the company’s ESG score.
The following are some benefits of knowing your company’s ESG score. It can help you assess your organisation’s position in the market regarding sustainability and other indicators and the potential for improving social outcomes and company management. ESG risks like climate risks help you to know the threats and opportunities in the market and thus gain a competitive advantage. It can also define other aspects of the organisation, such as workplace inclusion and diversity, that require consideration.
Higher ESG scores are likely to attract investors’ attention, so it is advantageous for firms to improve their ESG scores. Through ESG-focused investment approaches, we can all contribute to creating a better future for everyone.
ESG ratings evaluate a company’s performance in three key areas: environmental, social, and governance factors. These ratings help stakeholders understand how a company performs regarding environmental issues, labour standards, gender equality, and corporate governance.
ESG ratings are helpful for investors in determining the best investment decisions based on organisations' sustainability. They direct investors towards firms that are good to invest in based on their values and handling of ESG factors.
Studies show that companies with good ESG scores are more likely to be profitable. These companies are generally more stable and more suited to the long-term view.
They are not since rating agencies employ different techniques and assign different weights to the factors. A multifaceted analysis is necessary to consider a company’s environmental, social, and governance performance from other agencies’ perspectives.
We can expect ESG rating and investment approaches to be more uniform, including better data coverage and increased disclosure. Since the concept of ESG investing is expanding, these ratings will also develop and improve.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
Join the community to receive exclusive market analysis and updates!
Ignite your financial journey with BitDelta's diverse asset classes.
