Investors today are starting to look beyond the bottom line to assess firm value and long-term sustainability. Environmental, Social, and Governance (ESG) disclosure give investors a way to recognize and comprehend essential concerns that are not usually taken into consideration on a standard balance sheet but have a considerable influence on a company's risks and prospects.
ESG is becoming increasingly popular among investors, and going forward, business plans will progressively incorporate it. Investors request new tools to evaluate firms' performance from an ESG perspective as the ESG industry grows.
For businesses and investors, making wise ESG decisions carries significant risk. Institutions like asset managers, pension funds, and endowments frequently rely on ESG scores or sustainability scores to do this. But what is the ESG score?
ESG Score Meaning
Simply put, an ESG score measures a company's long-term exposure to environmental, social, and governance risks that are usually neglected during typical financial analysis. These risks include matters like energy efficiency, employee safety, and board diversity, which all have serious financial ramifications.
A company with a good ESG rating manages its ESG risks better than its peers, whereas a company with a bad ESG rating has a more significant average exposure to unmanaged ESG risks. Financial analysis and ESG ratings for companies can work together to give investors a better picture of a company's long-term prospects.
Also Read: The ESG Rating Phenomenon: A Guide to Understand ESG Ratings
What do ESG Scores Measure?
Each ESG element has a unique set of quantifiable standards that determine the ESG score as a whole.
Environmental criteria assess a company's effects on the environment and its attempts to mitigate those effects. The social environment of a corporation, such as its workers or nearby towns, is measured by social criteria. Corporate responsibility, which may include senior management obligations or shareholder rights, is measured by governance criteria.
An organization's commitment to good environmental stewardship, willingness to enhance local communities, and corporate governance responsibility should all be reflected in an ESG score. The following are some examples of criteria that fit into each of the three categories:
Environmental criteria
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Biodiversity and land use
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Carbon footprint
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Climate policies
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Natural resource conservation
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Waste byproducts
Social criteria
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Social vulnerability
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Consumer protections
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Disadvantaged or priority populations
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Supply chain management
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Health and demographic risk
Governance
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Accounting practices
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Board of Directors' diversity
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Business ethics
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Executive compensation
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Pay ratios
Now that we know what sustainable companies include in their ESG score reports, let us see how is ESG score calculated.
Also Read: ESG and Sustainable Investing: A Guide for ESG-Focused Investors in 2022
How to Calculate ESG Score?
Based on information acquired from various sources, including securities filings, voluntary corporate disclosures, governmental databases, academic studies, and media reports, each ESG rating organization has created its standards for evaluating ESG performance. Most rating providers can use any ESG data that a company has made voluntarily accessible through frameworks including the Global Reporting Initiative (GRI), the Value Reporting Foundation's (VRF) SASB Standards, CDP, and the UN Sustainable Development Goals (SDGs).
ESG indicators, such as a company's carbon emissions, board diversity, or safety protocols, are converted by the corporations' using analysts and algorithms into segregated environmental, social, and governance ratings that are then combined into a single main score.
The ESG score calculation methodology can be determined in essentially two different ways:
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A qualitative approach is based on information gathered through surveys, incorporating data from other sources, and ultimately analyzed using various techniques,
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A quantitative approach based on publicly available information released by the firm in accordance with international standards.
Following the first approach and assessing ESG performance solely through information self-declared by the firm, the most considerable risk is an incomplete evaluation due to a lack of data and a partial reporting technique. Contrarily, alternative data produced by the organization's external stakeholders might offer a fully unbiased and accurate perspective on the sustainability metrics.
Also Read: ESG and Impact Investing: The Future of Responsible Finance
Who Calculates ESG Score?
Agencies, research, and analysis firms are among the third-party entities that review businesses and issue an ESG score. These rankings are based on ESG performance and frequently evaluate businesses against their peers. The following are some of the biggest ESG grading companies:
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The MSCI ESG score is one of the ESG evaluation systems that are most frequently cited. Around 8,500 corporations and more than 680,000 worldwide fixed-income and equity instruments, including ESG funds, are scored by MSCI.
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Bloomberg ESG Data Services provides information on more than 11,000 businesses in 102 nations.
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Each year, the Business Knights Global 100 rates the effectiveness of corporate sustainability.
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Sustain analytics ESG Risk Ratings assist investors in identifying ESG risks associated with over 12,000 firms.
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Among the top 2,500 biggest corporations, the Dow Jones Sustainability Index Family reflects the top 10% of sustainable businesses.
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Thomson Reuters ESG Scores assesses the environmental, social, and governance scores of over 6,000 firms worldwide.
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RepRisk compiles and examines ESG ratings for more than 160,000 private and public enterprises using artificial intelligence.
What is a Good ESG Score?
An ESG score, which ranges from 0-100, allows investors to compare a company's performance to that of its competitors in the same industry and businesses from different sectors. Poor performance is defined as a score of less than 50, and excellent performance as a score of more than 70.
Additionally, ratings might be categorized as excellent, good, mediocre, or poor:
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A firm with an excellent ESG score will operate with little to no internal or external issues and adhere to best practices in all ESG categories.
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A corporation with a good ESG score adheres to best practices in all ESG categories and has no adverse environmental or social effects.
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A company's average ESG score shows if they are on pace to satisfy ESG standards or actively pursuing important ESG objectives.
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A poor rating shows that no best practices are being used, which signifies that the business is having a detrimental influence on the environment and is mistreating its staff.
How to Improve ESG Score?
Businesses that are ESG-driven experience a variety of advantages and are more likely to understand their business. This helps them to reduce ESG risks and opportunity chances that will help them advance and prosper. Investors who want to ensure their investments are strong financially (and socially) are drawn to these types of firms. Managing ESG might be difficult, but there are five techniques to improve ESG ratings to attract reliable investors.
Implement ESG Into the Culture of Your Company:
ESG is more than just a list of things to accomplish. It must be deeply established in the culture of your business and act as the inspiration for all your decisions and deeds. Initiatives that are sincere and centered on moral conduct, environmental sustainability, and social awareness get your company closer to actual social change. You will see an improved ESG rating as a result of this.
Perform a Materiality Analysis:
It might be challenging to determine what non-financial information is significant and what must be disclosed. Finding the ESG issues that matter the most to your company and your investors may be done with the aid of a materiality evaluation. You can direct your efforts and adjust your plan when you know investors carefully scrutinize the areas. This evaluation can better align and streamline corporate procedures and produce more precise and understandable reports. Your ESG rating can go up thanks to all of this.
Keep an Eye on Your Ratings:
Investors and other stakeholders are often looking at your ESG scores. Because of this, you need always keep your ESG rating criteria in mind when making decisions. You must first recognize where you are successful and where you need to improve if you want to raise your ESG rating. Engage with rating agencies' reports regularly. By conducting regular, detailed evaluations, you may enhance your efforts, raise your ESG rating, and convey the information that matters most to your investors.
Follow Global Frameworks:
Information about investments is provided to investors by international standards. Investors frequently employ several frameworks when choosing which investments to make, even though there is not a universal agreement on criteria for reporting ESG information. Look into the following:
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The Global Reporting Initiative (GRI) is the most extensively utilized standard for ESG reporting.
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The Sustainability Accounting Standards Board (SASB) assists companies in disclosing financially significant information.
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The Task Force on Climate-Related Financial Disclosures (TCFD) has developed guidelines to facilitate accurate climate-related disclosures.
These international guidelines act as a manual for companies looking to adopt an ESG strategy that would boost ratings and win over investors.
Submit Investment-grade Data:
Investors search for consistent, accurate, comparable, and understandable ESG information when evaluating investment possibilities.
To produce investment-grade data, adhere to the following standards while gathering ESG data:
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Accuracy: Implement comprehensive data-collecting methods.
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Limitations: The fiscal year and business ownership model should be included in the data.
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Consistency: To assure comparability, use trusted international standards.
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Data submission: Please provide raw and normalized data.
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Timeliness: Information must follow the yearly reporting schedule.
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External assurance: Have a third party assess your data.
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Balance: Include both good and negative facts in your presentation.
The information required for a good ESG rating will be presented if you keep these factors in mind while presenting ESG data.
Also Read: Sustainability in Tech: 3 Ways for Companies to Become More Sustainable
Importance of ESG Scores
Investors favor businesses with higher overall ESG ratings because they often have fewer liabilities, making raising financing and attracting top executives simpler. Additionally, these businesses enjoy fruitful stakeholder connections and a solid brand reputation. Each of these elements affects a company's profitability and bottom line.
Investors can evaluate a company's intents and actions using its ESG ratings, including how it treats its employees, how its board of directors decides, and if environmental problems are prioritized.
Investors may be persuaded to invest in a company with a high ESG score if its values align with their own or if the company is sufficiently shielded from potential risks related to pollution or bad governance. A firm with a poor ESG score can deter an investor who is concerned about ESG.
Environmental, social, and governance implications are considered the worst for businesses with poor ESG scores. Poor ESG ratings have also been associated with declining employee mental health and increased poverty levels in the company.
Also Read: The Sustainability Investments Revolution & its Impact on Climate Targets
Challenges with ESG Scores
Investors should not just rely on ESG ratings to guide their investment decisions, even if ESG data may be helpful when paired with other indicators. There are several challenges with the current lack of regulations and openness around the criteria used for grading, and the ESG score is not a reliable indicator of market performance on its own.
Although the House of Representatives has proposed legislation mandating public firms to report ESG indicators on a weekly and annual basis, ESG disclosures are not yet legally required in the United States. Aside from that, the Securities and Exchange Commission (SEC) has put forward new disclosure guidelines regarding topics like board diversity and climate risk.
Companies can utilize frameworks like the SASB Standards to direct disclosures in several industries in the interim, although adoption is optional. ESG scores will only offer a single piece of the ESG puzzle unless there is international consensus on ESG guidelines and evaluation systems.
Getting Started with ESG Scoring
Whatever third-party entity assesses a company's ESG score, your ESG ratings are only as good as your ESG data and disclosures. Setting ESG goals, identifying the essential metrics and results pertinent to your sector, and ensuring the data is trustworthy and transparent are all excellent places to start.
With a presence in New York, San Francisco, Austin, Seattle, Toronto, London, Zurich, Pune, Bengaluru, and Hyderabad, SG Analytics, a pioneer in Research and Analytics, offers tailor-made services to enterprises worldwide.
A leader in ESG Consulting services, SG Analytics offers bespoke sustainability consulting services and research support for informed decision-making. Contact us today if you are in search of an efficient ESG integration and management solution provider to boost your sustainable performance.
