ESG Ratings and Standards
As we know, ESG ratings and standards are very necessary when measuring sustainability of the business. In this section, we will elaborate more about the 5 rating systems mentioned in the previous introductory section and make detailed comparisons among them.
Background: what is ESG risk?
Environmental risk: un-ecofriendly actions
Social risk: labor right violations
Governance risk: ignorance of stakeholders
Before exploring the ESG rating system, we need to clarify what ESG risk is. ESG risk encompasses the possible financial and reputational hazards that enterprises encounter as a result of environmental, social, and governance aspects. Such risks have the potential to influence a firm's long-term operational results, its ability to comply with regulations, and the confidence that investors place in it.
Environmental risks involve vulnerability to climate change effects, adherence to pollution control regulations, and the depletion of natural resources. Take an energy sector company as an instance; if it doesn't make the shift to more environmentally friendly technologies, it might incur regulatory fines and see a decrease in investor enthusiasm.
Social risks encompass issues such as labor rights violations, workplace safety, and consumer protection. A retail company facing allegations of poor working conditions in its supply chain may suffer reputational damage and financial losses.
Governance risks pertain to corporate ethical standards, the diversity of the board of directors, and the level of transparency. A company with a past record of fraud or weak corporate governance practices is likely to witness a decline in shareholder trust and may also face legal repercussions.
Understanding ESG risk is essential for businesses and investors, as it helps in assessing potential vulnerabilities and making informed decisions about sustainability strategies and investments. Also, ESG risk is a very important factor considered in every ESG rating system.
MSCI ESG Ratings
MSCI ESG Ratings assess companies by considering their vulnerability to ESG risks that are unique to their respective industries, as well as their proficiency in handling those risks when compared to other companies in the same field. These companies are assigned ratings on a spectrum that spans from AAA, signifying a leadership position, to CCC, indicating a lagging performance. The rating methodology entails an in-depth examination of thousands of data elements related to crucial aspects like climate change, the utilization of natural resources, human capital management, corporate governance practices, and product safety.
The specific rating is listed as follow:
“Laggard” refers to “a company lagging its industry based on its high exposure, and failure to manage, significant ESG risks”; “Average” refers to “a company with a mixed or unexceptional track record of managing the most significant ESG risks and opportunities relative to industry peers”; “Leader” refers to “ a company leading its industry in managing the most significant ESG risks and opportunities.
MSCI employs a methodology grounded in specific rules. This approach integrates information that is accessible to the public, disclosures made by companies themselves, and additional data from various alternative sources. Investors use MSCI ESG Ratings to identify ESG leaders and laggards in various industries, aiding their decision-making in sustainable investing.
Sustainalytics ESG Risk Ratings
Sustainalytics, which is part of Morningstar, provides ESG Risk Ratings. These ratings assess the extent to which a company is exposed to ESG risks and the effectiveness of its management of those risks. In contrast to MSCI, whose emphasis is on a company's performance in comparison to others in the market, Sustainalytics gauges the actual, absolute levels of ESG risks faced by a company. Companies are each given an ESG Risk Rating score between 0-100 (lower is better) and categorized into five risk levels: negligible, low, medium, high, and severe.
Sustainalytics divide the exposure of ESG risks of companies into manageable risk and unmanageable risk. The manageable risk is further subdivided into managed risk and management gap. Sustainalytics evaluate the unmanaged risk, which is the sum of unmanageable risk and management gap.
Sustainalytics assesses risk exposure by considering industry-specific risks and management indicators. These ratings are beneficial for investors as they enable them to identify which companies are confronted with substantial ESG risks and evaluate how successfully those companies are working to reduce such risks. The widely adopted rating system plays a crucial role in formulating and implementing strategies related to integrating ESG factors into investment decisions, screening potential investment opportunities based on ESG criteria, and engaging with companies on ESG issues.
FTSE Russell ESG Ratings
FTSE Russell, a subsidiary of the London Stock Exchange Group, provides ESG Ratings based on a broad set of ESG themes. The ratings range from 0 to 5, with higher scores indicating better ESG performance.
Companies are assessed across three main pillars: environmental, social, and governance. There are 14 ESG standards (ESG themes) being used for evaluation, which are further subdivided into 330 data points (indicators).
FTSE Russell has crafted its methodology in a way that it corresponds with the sustainability standards and frameworks recognized globally. The ESG Ratings provided by FTSE Russell are extensively utilized by institutional investors. These investors rely on these ratings to create indices that center on environmental, social, and governance (ESG) factors. Additionally, they use the ratings to keep an eye on the risks within their portfolios and to ensure that they are adhering to the relevant regulatory demands.
Global Reporting Initiative (GRI)
The Global Reporting Initiative (GRI) is one of the most widely adopted ESG reporting frameworks. Unlike MSCI, Sustainalytics, and FTSE Russell, which provide ESG ratings, GRI focuses on sustainability reporting standards that organizations can follow to disclose their ESG performance. GRI helps to promote information transparency worldwide, and its unique standards concern various stakeholders – investors, policymakers, capital markets, and civil society. Therefore, GRI reports are widely used by stakeholders to assess a company’s long-term value creation and sustainability impact.
GRI’s standards are structured to provide a comprehensive, comparable, and transparent reporting framework for companies of all sizes and industries. The standards cover economic, environmental, and social topics, helping organizations communicate their sustainability efforts to investors, regulators, and the public (for more specific standards, access GRI - GRI Standards English Language).
Task Force on Climate-related Financial Disclosures (TCFD)
The Task Force on Climate-related Financial Disclosures (TCFD) provides a framework for organizations to disclose climate-related financial risks and opportunities. Established by the Financial Stability Board (FSB), TCFD focuses on integrating climate risk considerations into financial reporting. It will become mandatory for companies to report on these disclosures by 2025 in the UK, although some companies will have to report earlier.
The framework put forward by the TCFD is organized around four essential aspects: governance, which pertains to how a company's leadership oversees climate-related matters; strategy, focusing on how the company considers climate risks and opportunities in its long-term plans; risk management, dealing with the identification, assessment, and mitigation of climate risks; and metrics & targets, involving the use of specific measures and goals to track progress.
Unfortunately, the TCFD disbanded in November, 2023. However, it surely provides a valuable evaluation framework for companies.
Comparing ESG Rating Systems
First, each ESG rating system serves a unique purpose and is used by different stakeholders for various applications. MSCI, Sustainalytics, and FTSE Russell provide ESG ratings that help investors compare companies and assess their sustainability risks. In contrast, GRI and TCFD offer reporting frameworks that enable companies to disclose ESG-related information transparently.
Another difference between the rating agencies is their methodology: MSCI and FTSE Russell employ a relative scoring system for ESG assessment, while Sustainalytics gauges absolute risk. In contrast, the Global Reporting Initiative and the Task Force on Climate-related Financial Disclosures offer reporting guidelines instead of scoring systems.
The Importance of ESG Ratings
As ESG considerations gain prominence, investors rely on these ratings to make informed choices, while companies use them to benchmark their sustainability efforts. However, challenges remain in the ESG rating industry, including inconsistent methodologies, data gaps, and varying transparency levels among rating providers. Efforts are underway to standardize ESG reporting and rating practices to enhance reliability and comparability.