ESG Ratings: How can a business’ environmental and social impact be measured?
By Katerina Mansour - 29 October 2020
Investors and consumers are increasingly attentive to the social and environmental impact of businesses. But measuring this impact is far from simple. Here we dive into the different methodologies for ESG ratings developed by Early Metrics and other institutions.
ESG (Environmental, Social and Governance) investing started all the way back in 2004, with a call to action from former UN Secretary General Kofi Annan. Annan wrote to over 50 CEOs of major financial institutions inviting them to partake in a joint initiative to integrate ESG into capital markets, within the framework of the UN Global Compact.
Since then, ESG investing has grown in importance worldwide, with increased awareness and adoption rates. According to Deloitte, the percentage of retail and institutional investors that apply ESG principles to at least a quarter of their portfolios jumped from 48% in 2017 to 75% in 2019. Furthermore, a 2018 U.S Trust Wealth and Worth Survey concluded new investments in ESG funds could total $20 trillion in the next two decades.
Driving forces include regulatory considerations, in addition to the evidence demonstrating ESG criteria play a role in a company’s success. In France, Article 173 of the energy transition law requires investors to explain how they incorporate ESG factors into their investment strategies. This has helped investors shift towards managing their assets with ESG criteria in mind.
Over time, data has helped illustrate how germane ESG principles are when trying to assess a company’s potential. Fidelity, which created its own ESG ranking system, was able to correlate higher rankings with better resilience at the peak of the Covid-19 crisis. Based on the company’s data, securities with higher ESG ratings performed over 10% better during the pandemic.
What is ESG investing?
Environmental, social and governance criteria are a set of non-financial performance indicators that include sustainable, ethical and corporate governance issues. Some of these issues might include a company’s efforts to improve its carbon footprint or the health and safety of its employees.
The philosophy behind the ESG criteria is to recognise the effect companies have on the environment and society as a whole and in turn, how their ESG policies can impact their own resilience and profitability. A company’s environmental policies might contribute to water pollution or energy waste. As a result, the company’s costs, its reputation and its regulatory compliance could be at risk. A company’s social policies might lead to low worker productivity and morale, then increasing the chances of high employee turnover or absenteeism. Lastly, a company’s governance could involve a lack of compliance, deteriorating relations with shareholders, lack of diversity within the leadership, corruption, and other factors that can impact a company’s financial standing or reputation.
With all of this in mind, investors have established that beyond financial indicators, a company’s success and longevity on the market is increasingly linked to ESG criteria. Of course, ESG principles are just one of many indicators investors will take into account in their decision-making process.
Benefits and challenges of ESG ratings and investments
While we can hope there are exceptions, most investors and businesses don’t embrace ESG principles for purely altruistic reasons. The core benefit for investors is to improve the risk-return characteristics of their portfolio. For businesses, benefits range from improved reputation, increased brand loyalty, better competitive positioning, lowered costs and increased chances of investment. Aside from these pragmatic benefits, businesses can also use ESG principles as a way of embracing their team’s values and convictions. So, whether it is intended or not, businesses with genuinely effective ESG policies can contribute to bettering the environment and society as a whole.
A lack of clear standards and significant differences in the data collected stand out as clear challenges when it comes to ESG ratings. Different companies will conclude different scores based on their analysis and interpretation of the information gathered. Another key challenge that can affect rating results is the quality of the information found or provided. Beyond issues of the data’s quality lies the question of its veracity. With regards to the environmental criteria, greenwashing is a key issue across industries today. Many businesses will make false or misleading claims regarding their environmental policies, or make empty gestures that ultimately have little to no impact. An example of this is carbon offsetting, which has been at the centre of controversy and debate.
Another challenge worth noting is that when assessing businesses’ ESG impact, a one-size-fits-all approach is unlikely to yield trustworthy results. A startup will not have the same resources available to put in place the same ESG strategies corporates might. A 500 Startups survey showed that 37% of entrepreneurs said it was too early for them to have ESG policies in place and 20% said that investors don’t care about them. Although startups are far from being exempt of these criteria, ESG ratings need to be adaptable enough to prevent unfair judgements of startups when compared to larger companies.
How ESG criteria are evaluated
A company’s ESG performance can be measured in a variety of ways, as there is no definitive standard on the market today. Several institutions, investors and third-party agencies have developed their own methods. For example, MSCI developed a proprietary AI platform that collects and standardises public data, company disclosure documents and news articles. The company’s analysts then follow standardised methodology to provide an ESG investing rating score from AAA (highest) to EEE (lowest).
Overall, while there is no set standard, most existing solutions tend to follow a similar pattern: data collection, analysis, conclusions, recommendations, scoring. In practice, this often happens through the use of questionnaires during interview processes, with documentation as evidence. EcoVadis, an agency specialised in CSR/ESG ratings, stands out as one of the key players on the market today tackling ESG evaluations with this type of methodology. B Lab has developed the B-Corp label, which is another example of a questionnaire-based assessment. Companies must answer 200 questions on topics related to governance, workers, community, environment and customers. Based on its overall score, a business can then be certified B-Corp. The B-Corp label is re-evaluated every two years to ensure it remains valid.
What criteria, questions, factors, evidence are considered to determine a company’s ESG impact? This part of the equation has almost been standardised, thanks to research, frameworks and documentation provided over time. The UN’s Sustainable Development Goals (SDGs), composed of 17 goals, 169 targets and 232 indicators, stand out as a valuable resource. Of the 17 goals, several can be directly tied to a company’s operations. Decent work and economic growth, clean water and sanitation, sustainable cities and communities, responsible consumption and production and climate action are some of the goals businesses can tackle. In turn, when assessing a company, the measures it has or has not put in place to achieve such goals can be evaluated to determine its ESG impact. The six Principles for Responsible Investment and the Equator Principles are also incredibly valuable resources that can be leveraged to help establish questionnaires and evaluation criteria.
A key challenge that is difficult to avoid, no matter what system is put in place, remains lack of disclosure or transparency. Not all companies will be willing or able to provide the same levels of transparency regarding their policies and practices. Considering ESG ranking is either done based on publicly available information or based on voluntarily shared information from the company itself, there will always be potential for mistakes. The Global Reporting Initiative (GRI) has developed a methodology for corporate reporting on ESG issues that aims to help standardise how businesses report on their ESG related policies. This, in turn, helps improve the availability of useful information. Continued efforts are needed in this area, so that key data will no longer be as challenging to acquire and verify.
Early Metrics creates an ESG rating suited for startup assessment
In response to client needs and requests, Early Metrics is developing its own methodology to measure a startup or SME’s ESG impact. Based on the UN’s 17 SDGs and existing regulations, Early Metrics has designed a set of criteria that best applies ESG principles to startups and SMEs. One of our main strengths comes from our in-depth knowledge of the startup ecosystem, in addition to our ability to structure and extract meaning from qualitative data provided by entrepreneurs.
Relying on an interview process, questionnaires and documentation (audits, certifications, etc.) provided by entrepreneurs, our methodology establishes an ESG ranking from A to D. The ESG module of our rating process helps identify a startup’s strengths and areas of improvement.
Our methodology focuses on the realistic and tangible ways in which smaller businesses can incorporate ESG principles within their businesses. It keeps in mind the key differences between smaller businesses and corporates in terms of their resources, impact and needs.
Ultimately, increased awareness of a corporate’s impact on society and the environment likely means ESG investing will continue to gain in relevancy. Furthermore, the Covid-19 pandemic has brought on budgetary constraints and limited the amount of funding investors provide. Now more than ever, picking the right company to invest in is key if investors are to benefit from a strong ROI. Evaluating a company’s ESG impact through independent ratings seems like an increasingly promising way to ensure one’s investment will be fruitful.