With the growth of environmental, social, and governance (ESG) in recent years, more investors and stakeholders are pressuring organizations to incorporate ESG ratings and benchmarks as part of their sustainability programs. In this article, we deep dive into what ESG ratings and benchmarking are, their importance to sustainability, how they are determined, and the challenges associated with them.
What are ESG Ratings?
An ESG rating is a method used to evaluate a company’s management of ESG risks and opportunities. Rating agencies may consider different factors, relying on in-depth assessments they have uniquely developed to score organizations. They may use questionnaires or draw information from various sources to determine the score of an organization’s various ESG factors.
Among these rating agencies, some are commercial, and some are non-profit organizations. They also range from being industry-specific, like GRESB for real estate, to more broad like CDP.
What is ESG Benchmarking?
Benchmarking is the process of comparing one organization’s ESG rating against the average industry performance and standards. These benchmarks rely on the large amount of data rating agencies gather during their assessments.
Benchmarking helps an organization know how its ESG efforts compare against competitors or others in their particular vertical. This allows organizations to better assess their performance over time and against their industry as a whole.
Why Are ESG Ratings and Benchmarks Important?
ESG ratings are important because they help investors and other stakeholders better understand a company’s priorities regarding ESG and sustainability and potential short and long-term risks. Some examples of ESG and sustainability risks include the cost to transition to lower emissions technology, the possibility of increased regulations, and increased frequency and severity of extreme weather events.
Insights from benchmarking help an organization evaluate current operations and compare processes to those utilized by industry leaders and competitors. This provides organizations with a more comprehensive view of performance and potential direction to create or improve existing ESG and sustainability initiatives.
How Are ESG Ratings and Benchmarks Calculated?
With so many different rating agencies, there is no one standardized approach to calculating ESG ratings and benchmarks. Each agency uses different methodologies and weightings for the numerous ESG factors employed. Some rating agencies use a letter-based rating system while others use a numeric-based rating system to reflect the company’s absolute or relative ESG risk or performance. Here are a few examples of different rating systems used by different rating agencies:
- A 7-point scale from AAA to CCC like MSCI uses
- A 8-point scale from D- to A like CDP uses
- A percentile basis using a scale of 1 to 100 like the CSRHub uses
Below is just one example of how ESG ratings are determined, using the methodology of the agency MSCI as a reference:
- Key ESG issues are identified by industry. MSCI selects the 35 most relevant issues to specific industries. For example, packaging material and waste is a key issue for the soft drink industry. This wouldn’t be a factor for industries that don’t physically package a product, such as technology infrastructure. Corporate governance key issues are included for all industries.
- Companies are scored on each key issue. MSCI analyzes 80 different exposure metrics and 270 governance metrics to score companies from 0 to 10 on each key issue. A low score means the company is heavily exposed to the issue and is not managing that risk effectively. A high score indicates an aggressive effort to mitigate the risk.
- Issues are weighted by potential impact. MSCI weighs key issues according to their timeline and potential impact. Issues that could have major environmental or social impacts within two years have the highest weights. Issues with lesser potential for impact and a timeline of more than five years have the lowest weights.
- Issue scores and weights are combined. Issue scores and weights are combined to produce an industry-adjusted numerical score from 0 to 10 for the rated company.
Rating agencies typically make separate assessments for each of the three components of ESG—E (environment), S (social), and G (governance)—which they then aggregate to compute an overall score.
What Are the Challenges with ESG Ratings and Benchmarks?
With the ESG rating industry being so highly fragmented with dozens of rating agencies and data providers, organizations face multiple challenges including:
Completeness of Data
It can be a challenge for an agency to ensure they have access to all the necessary and accurate data to perform a proper assessment. This can lead to some agencies making assumptions about the organization and its ESG performance to fill these data gaps and provide a score or rank.
Standardization & Consistency
Due to the large number of agencies and lack of standardized approach to ESG ratings, there is also a lack of correlation between ESG ratings from different agencies. This can lead to vastly different scores from different agencies for the same company.
With no consensus about how to rate a company properly, each rating agency operates in its own way and to its own standards. This makes it difficult for stakeholders and companies themselves to compare ratings from different agencies.
Reliability Issues
On top of the challenges listed above, the reliability of ESG ratings has been criticized due to:
Lack of transparency in data sourcing.
ESG ratings have been making the news recently for a lack of transparency in data sourcing. ESG ratings are a useful tool only if they are data-backed, reliable, and objective.
Conflicts of interest due to the sale of consulting services to rated companies.
The practice of rating agencies offering paid services to companies they have rated to increase their ratings at least raises serious concerns about whether this compromises the independence of those ratings.
Conflicts of interest when a rating provider rates an affiliated company.
Research indicates that “sister firms” of an ESG rating agency receive higher ratings from the affiliated rating agency than they do from independent firms.
Despite these challenges, ESG ratings and benchmarks can play a huge role in helping organizations stay motivated and continue to improve their ESG and sustainability efforts when utilized properly. Everyone loves getting a gold star for their efforts but ensuring the rating agency and methodology an organization selects is reliable, transparent, and appropriate to their industry is one of the keys to using ratings and benchmarking to their full potential.
Not sure how to improve ESG scores or tackle benchmarking? Contact us today to learn how the FigBytes sustainability platform can streamline ESG data and program management for your organization.
Additional Sources:
- Manar Al-Shaebi, FigBytes Solutions Engineer
- Rajiv Jalim, FigBytes Director Solutions Engineering
