ESG Score: What It Is and How ESG Rating Agencies Calculate It

ESG scores measure environmental, social, and governance risks a potential investment may face. Learn how they are calculated and why they are important when choosing what companies and funds to invest in.

SustainFi   Updated March 3rd, 2022

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What is an ESG score?

ESG stands for environmental, social, and governance. ESG ratings measure a company’s exposure to environmental, social, and governance risks like climate change.

ESG investors use these scores to add factors like carbon emissions to financial metrics like profits when they decide to invest. Companies with better ESG scores are seen as better at managing risks and are more likely to be included in ESG investors’ portfolios.

Global ESG assets are growing rapidly, reaching $3.9 trillion in September 2021. Investors who manage money sustainably include institutions like pension funds and university endowments, mutual funds and ETFs, and even robo-advisors. Individual investors also care about sustainability. According to a 2021 survey by Morgan Stanley, 99% of millennials are interested in sustainable investing.

Being included in more funds is good for companies’ stock prices. Unsurprisingly, management teams and Boards are taking ESG scores more seriously.

Environmental, social, and governance criteria

ESG scores are composed of three types of criteria: environmental, social, and governance.

The E or Environmental in ESG measures how a company is doing with regards to the Planet’s climate. Environmental factors include carbon emissions, decarbonization targets, the use of renewables like wind and solar, energy efficiency, the use of water, pollution, biodiversity, packaging waste, and waste disposal. Compliance with government regulations like EPA regulations is also taken into account. In addition, some companies pledge to be carbon-neutral (or even carbon-negative like Microsoft) by a certain date. These pledges can lead to a better ESG score.

The S or Social in ESG tries to put a number on a company’s relationships with its employees, customers, suppliers, and local communities. Companies that have issues with labor unions, lawsuits alleging discrimination and harassment, complaints from the local community or from customers have worse ESG scores. Although factors like employee relations are hard to quantify, ESG ratings try to do that. Rating agencies can look at variables like the existence of anti-harassment policies, health and safety protocols, and customer complaints. 

The G or Governance in ESG measures how a company treats its shareholders. Unlike environmental and social components, governance has been paramount to investors for a long time. Governance scores include factors like Board independence and diversity, executive compensation, transparency, and potential conflicts of interest.

Who calculates ESG scores?

Over a hundred rating agencies calculate ESG scores. The best-known agencies are MSCI, Sustainalytics (owned by Morningstar), ISS, RepRisk, Refinitiv, Bloomberg, S&P Global, and FTSE.

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How is an ESG score calculated?

There is no single way of calculating ESG scores, so rating agencies use different methodologies and rely on different data sources. In the U.S., there is no standard way of disclosing ESG risks. Companies file sustainability reports, but they don’t have to disclose comparable data. Many companies don’t even fully disclose their greenhouse gas emissions.

Sustainability reporting standards, such as those proposed by the Sustainability Accounting Standards Board (SASB), do exist, but adopting them is voluntary. So deciding what data to use is subjective, and agencies have to rely on less than complete data reported by the companies they rate.

Agencies also weigh E, S, and G factors differently. Some agencies weigh environmental factors more highly than governance; others do the opposite. Even what makes up a strong governance score can vary; some agencies include corporate lobbying, others do not.

Here is how two of the best-known ESG rating agencies calculate ESG scores.

MSCI ESG scores

MSCI rates over 8,500 companies globally. According to Bloomberg Intelligence, 60% of ESG fund money is in funds that rely on MSCI’s ratings. Their ESG ratings range from leader (AAA, AA) and average (A, BBB, BB) to laggard (B, CCC).

Credit: MSCI

The agency collects thousands of data points for each company, including both corporate disclosures and alternative data sources. Alternative data includes hundreds of media, academic, NGO, regulatory, and government sources. The world’s biggest asset manager, BlackRock, is MSCI’s top customer – BlackRock’s iShares family of over 30 ESG funds relies on MSCI ESG ratings.

Importantly, MSCI incorporates the Materiality Map approach into their ratings, recognizing that some ESG criteria are key to some industries but not to others. For example, water use and toxic waste disposal are more important for a mining company than for a software company. Likewise, “biodiversity and land use” would not be relevant for a software company, but it can be highly relevant to an agricultural business.

As an example, here is how MSCI came up with the rating for International Paper (NYSE: IP), a U.S.-based producer of paper products.

MSCI uses both artificial intelligence (AI) and a team of 200+ human analysts to collect, analyze, and validate the data. They recalibrate their ESG ratings model annually, including feedback from large investors.

Sustainalytics ESG scores

Another top ESG rating agency, Sustainalytics (owned by Morningstar), assigns ESG risk scores to companies. Risk scores range from negligible to severe, and a high ESG risk score is bad.

Credit: Sustainalytics

Sustainalytics rates companies on 20 material ESG issues, which are underpinned by 250 ESG indicators. Here are the 20 material ESG issues:

  • The environmental and social impact of products and services
  • Human rights
  • Data privacy and security
  • Business ethics
  • Bribery and corruption
  • Access to basic services
  • Community relations
  • Emissions, effluents, and waste
  • Carbon – own operations
  • Carbon – products and services
  • Human rights – supply chain
  • Human capital
  • Land use and biodiversity
  • Land use and biodiversity – supply chain
  • Occupational health and safety
  • ESG integration – financials
  • Product governance
  • Resilience
  • Resource use
  • Resource use – supply chain

Like MSCI, Sustainalytics uses both AI and human analysts. Their AI scans over 60,000 media sources, and their team of 350+ human analysts provides human validation. Besides corporate disclosures, they review data like regulatory filings on product recalls and NGO sources.

What is a good ESG score?

A good ESG score depends on the rating agency. MSCI ESG leaders have a score of AA or AAA. With Sustainalytics, a good ESG score is a negligible or low risk score. ESG scores from Refinitiv range from 0 to 100; the companies in the fourth quartile (75-100) are the best ESG companies. ESG scores from S&P Global also range from 0 to 100, the higher the better.

Is a high ESG score good?

It depends on who calculates it. For most ESG rating agencies, a high ESG score is, indeed, a good score. But there is a notable exception. Sustainalytics calculates ESG risk scores, and a high risk score is bad. The best companies have a low risk score.

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Save and invest spare change

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Work with human advisors

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Minimum

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Why are ESG scores important?

ESG scores let investors compare companies to their peers. Good ESG scores can lead to a higher stock price. As ESG fund assets grow, more investors include companies with the best (or better-than-average) ESG scores. Companies with weak scores are more likely to be left behind. Higher stock prices benefit shareholders, management teams, and employees with stock options.

Companies with poor ESG scores are shown to be at a higher risk of bad things happening. ESG-related issues can lead to environmental fines and penalties, product recalls, and lawsuits. A 2019 Bank of America study found that a significant decrease in ESG scores often preceded bankruptcy. They also found that companies with good ESG scores had less volatile earnings.

Governance, the G in ESG, also matters. For example, Bloomberg Intelligence found that companies with the same chairman and CEO report a 1% lower return on assets. They also found that companies where the CEO sits on two or more external Boards underperform. Another study from McKinsey found that diverse companies generate above-average returns. 

What are the limitations of ESG scores?

First, ESG scores are subjective and rating agencies disagree. An MIT study found that the ESG rating correlation among different agencies was only about 60%, compared to 99% for corporate bonds. This is not surprising: credit rating agencies use roughly the same financial data, but there is no compulsory standard for ESG reporting. Nor is there any regulatory oversight of ESG rating agencies.

As an example, BP plc is a British oil and gas company that explores and refines oil. MSCI gives BP an A rating, which is average. MSCI recognizes that BP is a leader in corporate governance, but it needs to work on issues like biodiversity and health and safety. In contrast, Sustainalytics gives BP a high risk score due to its climate change exposure.

Second, ESG scores generally measure the environmental, social, and governance risks a business may face. They are a tool for investors to decide if it’s a good financial decision to invest or not. However, some commentators feel that ESG scores should be measuring the impact a business has on the planet instead.

Third, ESG ratings generally measure how a company fares relative to its peers, not across industries. This confuses a lot of people. So oil companies are compared to oil companies, and software companies are compared to software companies. Some oil companies can get a good ESG score because they are better at climate change adaptation than their peers. But some critics think that companies should be compared across industries, so all oil companies should have bad ESG scores.

How to find a company’s ESG score

Although most agencies hide company ESG scores behind a paywall, several offer access free of charge. Here is where to find ESG scores from several agencies:

Besides individual companies, rating agencies rate mutual funds and ETFs. However, free access is pretty basic. To get detailed reports, you need to be a customer.

ESG score example: Tesla

You might think that Tesla, which is advancing the electrification of cars, would get high ESG ratings, but that is not the case. We are going to look at Tesla’s ESG ratings from two agencies.

As of March 3, 2022, MSCI assigned Tesla an A ESG score, which is average among car manufacturers. Although Tesla is a leader in the “Opportunities in Cleantech” Category, it is a laggard in “Product Safety and Quality” and “Labor Management.” Indeed, there were multiple reports of Tesla batteries catching fire, and the company is facing lawsuits alleging racial discrimination. MSCI is also not convinced that Teslas are that good for the environment due to their high product carbon footprint.

Credit: MSCI

Sustainalytics puts Tesla in the “Medium Risk” category. Although Tesla does well on environmental metrics, the agency is not happy with Tesla’s high social risk score and, to a lesser extent, its governance. Sustainalytics also notes a significant controversy level attached to the stock.

Credit: Sustainalytics

NOT INVESTMENT ADVICE. The content is for informational purposes only; you should not construe any such information as investment advice.

🔔 Interested in investing in funds with good ESG scores? Check out the top ESG funds.

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