An objective evaluation of a company, a fund, or a security’s performance measured against Environmental, Social, and Governance (ESG) criteria
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An ESG score is an objective measurement or evaluation of a given company, fund, or security’s performance with respect to Environmental, Social, and Governance (ESG) issues. Specific evaluation criteria vary between the different rating platforms that issue ESG scores; however, they all fall within one (or more) of the E, S, or G categories.
ESG scoring systems tend to be either industry-specific or industry-agnostic. Industry-specific scoring systems assess issues that have been deemed material to the industry at large. Industry-agnostic ESG scores tend to incorporate widely accepted factors that are meaningful across industries – issues like climate change, diversity, equity and inclusion (DEI), and human rights.
ESG rating platforms determine a weighting for each measurement criterion; then, they assess an organization’s performance against each criterion. An organization’s final ESG score is typically a sum-product of the criteria ratings and the (proprietary) criteria weightings.
An ESG score is an evaluation of an organization’s performance against various sustainability metrics (related to either environmental, social, or governance issues).
ESG scores are generated by rating platforms where analysts evaluate corporate disclosures, conduct management interviews, and review publicly available information about an organization to provide an objective rating of the organization’s performance.
Scores are used differently by different stakeholders (i.e., investors vs. employees), and rating platforms have evolved to reflect this variety of use cases.
How Do ESG Scores Work?
Increasingly, management teams at public companies are being required (by stock markets and government bodies) to provide ESG disclosure with their quarterly and annual reporting. In order to report clear and relevant metrics in a standardized format, they will select a reporting framework.
Some common frameworks are the Global Reporting Initiative (GRI), the Principles for Responsible Investment (PRI), and the Sustainability Accounting Standards Board (SASB). When company management teams disclose ESG information without the use of an appropriate framework, it’s often referred to as Greenwashing.
Stakeholders and rating agencies interested in producing ESG scores will review these company or fund disclosures, then conduct management interviews, compare results and metrics to other companies in the industry, and present an ESG score for the company.
ESG raters help bridge the gap between an organization’s disclosures and the general public’s interpretation of the organization’s ESG behaviors and performance. Scores are also used by the financial analyst community to help inform capital allocation decisions.
Who Measures Performance and Assigns an ESG Score?
These scoring systems can be from finance and investment firms, consulting groups, standard-setting bodies, NGOs, and even government agencies. Broadly speaking, however, there are two major categories of raters that generate ESG scores – these are external and internal stakeholders.
1. External Stakeholders/Rating Platforms
External stakeholders consume company disclosures, review publicly available information, and conduct primary research with company management about the organization’s sustainability efforts. Examples include:
ISS (or Institutional Shareholder Services) is one of the largest institutional investor advisory services in the world; they have a variety of scoring systems, including issue-specific scores (like its “Carbon Risk Rating” or its “Water Risk Rating”) and category-specific measures (like its “Governance Score”), as well as an overall “Corporate Rating.”
CDP (the Carbon Disclosure Project) is a non-governmental organization that publishes ESG ratings, particularly around environmental factors. CDP is known for its level of rigor in conducting primary research directly with issuers, as opposed to relying on an organization’s voluntary disclosures.
MSCI, Sustainalytics, and S&P TruCost are examples of financial services entities that measure and present ESG ratings for public consumption.
2. Internal Stakeholders
Internal ESG scores, in the form of ESG scorecards, are also used to gauge performance within an organization. In fact, more and more entities are creating in-house scoring systems to monitor and report on their own performance. The purposes of internal ratings include, but are not limited to:
Comparing performance across business units or geographic markets.
Measuring actual results against specific issues affecting company stakeholders (like customers, suppliers, or employees).
High ESG scores are a constantly-moving target as the scores are frequently impacted by the performance of other industry players, macro industry trends, and alterations to the scoring platform’s internal methodologies.
Scores are also hard to assess in “absolute” terms. However, all other things being equal, an organization that consistently achieves high ESG scores across a variety of rating platforms is likely to perform well relative to its peers.
Leveraging insight from a given ESG score in a meaningful way can only be achieved by understanding the broader context of the situation, as well as knowing what inputs are being measured (and what kind of weightings are being used) to arrive at a particular score.
How are ESG Scores Used in the Market?
ESG scoring systems are created for different use cases and for different stakeholders (based on their associated needs); some are designed to support capital allocation decisions (like investments or assessing credit risk), while others may support human capital management and staffing decisions.
For example, CDP (The Carbon Disclosure Project) is an NGO scoring system for corporate performance on a variety of environmental issues like carbon emissions, climate change, water, and forestry. CDP is popular within the investment community, as asset managers can use positive or negative screening to identify top (or bottom) performers with respect to environmental issues.
Just Capital is a consumer-focused NGO scoring system that assesses corporate performance on stakeholder issues – such as how a company creates value for its employees, suppliers, and local communities. Just Capital may be leveraged by consumers or prospective employees when searching for a company to buy from (or to work for).
In virtually all cases, these methodologies are being updated regularly, making one’s understanding of evolving ESG factors important when trying to interpret or get actionable insight from a given score.
This article was prepared in collaboration with Rho Impact.
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