Understanding how businesses record ESG data and earn ratings can help you make better-informed investment decisions.
It’s no secret that investors are embracing sustainable investing – a process that applies environmental, social and governance (ESG) data to an investment portfolio.
And Europe is leading the way. Morningstar data indicates that Europe held 83 percent of global sustainable funds’ net assets at the end of 2021 . “We’ve seen investments in our discretionary ESG portfolio increase threefold in just under three years, up to August 2022,” explains Stephen Metcalf, head of Sustainable Investing for RBC Wealth Management in the British Isles and Asia.
As interest in the ESG sector has grown, the data sets and ESG ratings systems underpinning what is deemed “sustainable” have also garnered attention. “Investors are increasingly interested in looking beyond the traditional financial statements of a company, and ESG data provides an additional lens with which to analyse a company’s health and direction,” Metcalf says.
But there is no unilateral methodology or rating scale for ESG standards. In fact, there are many, with more and more traditional investment data houses and credit rating agencies providing their own interpretations of ESG data. Despite these firms often sharing the same goal, the majority use different frameworks, measures, key indicators and rating scales to analyse a company’s ESG credentials.
“With so many divergent approaches, it can be challenging for investors to compare and fully understand the meaning of the ESG ratings,” explains Metcalf. “It’s important to take a step back, remind yourself what your investment goals and values are, and then proceed with diligence.”
ESG ratings represent a company’s resilience to long-term, financially relevant ESG risks – that is, any material information that could have a significant impact on a company’s future financial condition or operations.
Material information could include anything from environmental data, such as annual carbon emissions and energy consumption; social data focused on issues like gender equity and human rights; and governance data that tracks a company’s approach to topics such as corruption and labour practices.
“Fundamentally, ESG ratings help investors understand a company’s priorities and identify any long-term risks to its financial value, as well as potential opportunities. This enables investors to build a holistic view of a company’s potential when making investment decisions and more closely align their portfolios to their values or sustainability objectives,” explains Metcalf.
But with so many different ratings systems in use, it’s important to understand the methodology in order to interpret the final rating.
“You might get a rating of 20 from one company, a AAA from another, and an E-2, S-2 and G-3 all for the same security, for example. This lack of interpretability has led to the ambiguity around ESG ratings,” says Metcalf.
Ratings will often vary from industry to industry too. Some rating providers use a relative-to-industry measure, while others might not consider the industry’s impact overall. Plus, ratings depend on the amount of information and data available from a company, which can vary drastically.
For example, one popular ESG rating system is the MSCI ESG ratings model , which scores a company against 35 key issues most material to an industry sector.
Source – MSCI ESG ratings key issue framework
These key issues are weighted according to their potential impact and immediacy, then the scores and weights are combined to produce an industry-adjusted numerical score from 0–10. The scores are then translated into an ESG rating that ranges from leading companies (AAA) to laggard companies (CCC).
Source – MSCI ESG ratings bar
But Metcalf recommends against relying on a single ESG ratings provider. “Saying everything above a certain rating is ‘good’ isn’t a representative approach. You really want to focus on transparent, objective and quantitative impact metrics that have sound methodologies behind them,” he explains. “We work with an alternative data provider that places transparency at the core of its model. This helps us cut through the more opaque ESG ratings to create a sustainability profile for each company our clients invest in.”
It’s also important to remember that ESG ratings do not clearly show a company’s impact on the world; rather, they show how ESG factors affect the company itself. Investors must be careful to not conflate the ratings with the company’s real-world impact.
Interpreting ESG ratings may seem complex, but the processes and data are still evolving. “As regulations dictating best practice become more concrete, there will be more opportunities for investors to integrate ESG insights into their portfolios,” explains Metcalf.
Regulation of ESG reporting and scoring is still in its infancy. There are existing regulations, such as the European Sustainable Finance Disclosure Regulation – introduced to improve the transparency of sustainable investment products – but there remains a clear need for data that minimises the subjectivity inherent in a number of ESG issues.
Standardised disclosure requirements will help investors more effectively analyse the inclusion of ESG-compliant companies in their investment portfolios. Similarly, more robust regulations will provide investors with increasingly reliable and transparent data to help them make better-informed investment decisions.
“Until more regulation is introduced, it’s important for investors to work with their financial advisors to understand how ESG data is applied to investments when developing their ESG portfolios,” says Metcalf.
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