ESG Rating 101. Don't skip!
Updated: Nov 21, 2022
Coined for the first time in 2004, the term ESG has been around for almost two decades and has been able to prove its significant role. Business went from reluctant to rush into ESG. The three letters E, S, and G have been all over the headline, whether as a management system, an investing style, or the whole rating market.
But what are they?
ESG management is a system that identifies three core non-financial aspects of any business, namely Environmental, Social, and Governance, in pursuing sustainability together with profitability in a long-term view. It is the expansion of management areas, lengthening the time frame of management, and completely shifting the objective of business management from Maximum Profit to Optimum Profit.
But they are non-financial angles, Right? How on Earth can we rank them?
Well, that is where the ESG Rating market bloom.
So does that mean ESG rating quantifies how good companies perform on these non-financial sides?
Not particularly.
What is ESG Rating?
An ESG rating does not measure a company's performance but rather the company's exposure to long-term environmental, social, and governance risks. Centuries traditionally, businesses often omit these risks on their financial report. Interestingly, ESG rating also looks at the company's opportunities when dealing with mentioned risks. Just like the ESG report, ESG rating aims to broaden investors' views, to help them make an informed decision. The other users of ESG rating could also be job seekers, employees, consumers, and the company itself to better understand the company's situation and performance to correctly align them with the expectations of society and the limits of our ecosystem.
So what are these mentioned risks?
The E in ESG. A rating agency may ask questions about a variety of subjects, including GHG emissions; water use, treatment, and discharges; carbon footprint policies; energy consumption and intensity; renewable energy; production of hazardous waste; deforestation; product reusability and recyclability; natural capital stocks depletion; and other operations practices that have an impact on public health.
The S in ESG. Human rights; the use of child or forced labor in supply chains; diversity and inclusion among employees and suppliers; fair representation and compensation; discrimination; personal data security and privacy; product safety; worker safety and well-being, cybersecurity risks; community relations; human capital development; family leave policies, and animal welfare are a few of the subjects covered.
The G in ESG. Some crucial angles are organizational structures; corporate compliance with state and federal laws; board diversity; executive compensation; board involvement and oversight of ESG issues; business ethics; conflicts of interest; accountability and transparency; codes of conduct; bribery and corruption; tax reporting, etc.
"ESG ratings focus on financial risks to a company’s bottom line. That is by design to help institutional investors assess such risks and to deploy capital in ways that maximize investment return over their time horizon."
MSCI
Good or Bad
What do good ESG ratings and bad ESG ratings mean?
A good ESG rating means a company is managing its environment, social, and governance risks well relative to its peers. A poor ESG rating is the opposite -- the company has relatively higher unmanaged exposure to ESG risks.
Repeat: ESG ratings may not always indicate whether a highly ranked company is actually leading the way in minimizing its negative effects on people, the environment, or efforts to create a more equitable and sustainable world.
Misconception: Better investing for better world - (MSCI). Not necessary or directly
Here the important words are Risk exposure and Peers.
“ESG has nothing to do with making the world a better place,”
Aniket Shah, managing director and global head of ESG at Jefferies Group.
So what does ESG answer?
" What ESG has to do within the capital markets is ensuring that you, as an allocator of capital, understand the risks associated with environmental, social, and governance issues from the perspective of how do you make the most amount of money in your investments?”
Aniket Shah, managing director and global head of ESG at Jefferies Group.
Blooming yet Divergent
It is a puzzle for companies to decide which raters to go with simply because there are too many options. As of 2018, there are 600+ ESG rating and ranking agencies out there, and this number does not seem to decrease. The most well-recognized and largest raters include MSCI, Sustainalytics, S&P Global, ISS ESG, and many more. Each agency has its own rating methodology, but in the end, the result is illustrated by either letter AAA, BBB, CCC; A, A-, B, B- or a numerical score, normally out of 100. What's more? It is the Prestigious list these agencies develop to name their ESG-rated champions.
Yet, it does not easy and simple as it sounds.
There is little clarity and alignment on definitions, including on what ratings or data products intend to measure.
IOSCO — the International Organization of Securities Commissions's report.
There are many frustrating challenges for ESG raters, companies, and users at the same time. Among them, it is worth mentioning some big rocks: what are the standards, methodologies, how to collect data, and what if there is no data?
Have you heard about the ESG Black Box?
Stay tuned for the answer in the next article!
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