As investors demand increased sustainability and transparency from companies, a need for quantifiable methodologies to evaluate investment funds and assess risk has arisen. Programs like Environment, Social and Governance (ESG) frameworks allow investors to compare corporations and funds along an independently-defined set of criteria.
If you’ve spent time online researching large companies and seeking out new investment opportunities, you’ll inevitably come across web pages that proclaim “Company X is a sustainable business”. They may even have a copy of their ESG report publicly available for investors to review.
But simply having an ESG program and providing an annual report isn’t enough. Companies need to show progress in their efforts to reduce their impacts and manage risks year over year. And investors need an objective means of comparing the outcome of these efforts across businesses and even across industries.
An ESG score is a shorthand way of making risk-based decisions by giving investors a single score to use, rather than having to review individual ESG reports and decide which values and elements of the framework to prioritize. It also gives a clearer picture of how risk changes and corporations make progress over time.
What is ESG Score?
An ESG score is a means of measuring risk and effectively comparing that risk across an investment portfolio, or between potential investments. Scores can be assigned to individual corporations or to an investment asset like an ETF or mutual fund.
ESG risk scores are set by third party investment research companies. This gives investors confidence that the scores are neutral and quantitative. Overall, an ESG score provides a big-picture view of the company’s operations, its risks and ability to manage them.
ESG scores have received some criticism though. Because there isn’t a standardized way of setting them, it can be hard to compare them or know exactly how they were determined.
How are ESG Scores Determined?
An ESG score for companies is determined by assessing performance and risk along a predetermined set of ESG metrics. These metrics will vary by company and industry, and also by the organization doing the rating.
For example, a manufacturer’s ESG score might be determined by prioritizing factors like water conservation and energy usage, while a real estate investment firm’s ESG score could weigh factors like transparency in leadership and community engagement more heavily. The reason for this variable approach is to make sure the score is appropriate for the industry and its risks, resulting in real quantifiable progress.
Becoming a truly sustainable business is not a one-size-fits-all undertaking. Many organizations will tout their sustainability accomplishments by reaching for low-hanging fruit or unquantifiable feel-good initiatives, without making any significant changes to their riskiest or most hazardous operations. An ESG score is only valuable if it truly takes into account which risks are appropriate to the company and which can truly be managed.
ESG scores also take into a consideration the balance between the presence of risk versus a company’s ability to manage it.
For example, a manufacturing company that uses a highly regulated and hazardous chemical in its production may be seen as higher risk, but if it has a strong track record of environmental and health & safety protection around the chemical, it may receive a higher ESG score. On the other hand, a company that has no chemical concerns in its operation, but makes no effort to reduce vehicle emissions from its fleet, may receive a lower score.
Rating organizations may also more strongly factor certain elements of ESG into their score based on their own values or priorities. This means one score might place greater emphasis on practices around preserving biodiversity or reducing waste generation, while another might more heavily favor human rights and data privacy protection.
What is Considered a “Good” ESG Score?
A good score is one that shows a minimum amount of risk. Depending on the rating company, the score might be numerical or an alphabetical rating.
As examples, Morningstar uses a numerical index on a scale of 0 to 100 for its ESG scores. The lower the score, the lower the risk. The Morningstar scores are:
- 0 and 10 – negligible
- 10 to 20 – low
- 20 to 30 – medium
- 30 to 40 – high
- 40+ – severe
By comparison, other rating services may use alphabetic ratings for ESG scores, similar to how they’d rate other investment risks. These would be:
- AAA and AA – Industry leaders going above and beyond to manage their ESG risks
- A, BBB and BB – These companies have a mixed or unexceptional track record in managing their ESG risks
- B and CCC – These companies are considered laggards who are at high risk of failure or exposure in their ESG program
Ultimately the lower the risk, the more desirable the company or fund is as an investment opportunity, though a low risk ESG score is rarely the only determining factor. Investors building an ESG-based portfolio will use these scores as part of a larger set of criteria to make investment decisions, weighing the ESG risks against the potential for financial return.
The starting point for any ESG score is to have a robust and documented ESG program in place. To learn more about ESG reporting, visit our comprehensive guide: What is ESG Reporting.