MAKING FINANCE MORE SUSTAINABLE PART I – THE ESG RATING

Dorsum ESG blog

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ESG (Environmental, Social, Governance) investments (or sustainable investments, as they’re usually called) are becoming more and more popular, and so is their impact on the value of global investments. In some of our previous blog articles, we have talked about the meaning of these letters and what expectations they present. The first part of this year’s ESG blog series will serve as an introduction to the topic that examines the ESG scoring system.

First, let us give a brief revision summary that also serves as an introduction, of what we look at when we give scores according to the individual letters of ESG:

  • E: „The environmental component requires research into a variety of elements that illustrate a company’s impact on the Earth, in both positive and negative ways.”
  • S: „Social factors consisting of people-related elements like company culture and issues that impact employees, customers, consumers, and suppliers – both within the company and in greater society.”
  • G: “The corporate governance component relates to the board of directors and company oversight, as well as shareholder-friendly versus management-centric attitude.”

In other words, the ESG factors have little to nothing to do with what a company produces or how they produce it. Therefore, it will not be surprising to learn that the top-ranking ESG companies are not necessarily the ones producing green energy or working on revolutionary technologies. This is just one aspect of the whole, because ‘being green’ does not by definition include whether the company’s employment policy covers gender equality, or that they are actively working on overcoming ethnic differences, or how their governing body board operates.

The popularity of companies rated as more sustainable is not only due to the increase in the number of responsible investors. Companies with high ESG scores – by meeting the requirements described above – promise to be stable and provide more fruitful investment opportunities. This is because they are transparent, with a consistent and forward-looking company policy, and these attributes curb factors that would negatively affect company value and prevent events that would greatly damage their image.

On the other hand, the reliability of each ESG scoring system and how much the extent to which it reflects the expectations placed on it can greatly vary because there is no universal formula, a globally accepted method for constructing calculating ESG scores. On the contrary, the criteria system can be constructed quite flexibly. A possible example of this is illustrated in the following figure, which identifies 10 questions within the topics that can be evaluated according to well-defined criteria when calculating a certain ESG score.

esg score

This, in turn, also means that every ESG scoring institution has its own unique ESG scoring system. Additionally, the result also depends on what the evaluated company decides to disclose about itself. The available data could be reliable or misleading, calling into question whether the company can even be properly scored. Of course, there are more recognized ESG reporting standards, such as SASB, TCFG, and GRI whose extensive, voluntary reporting somewhat helps in creating transparency and uniform understanding.

Bloomberg, EcoVadis, FTSE, Global 100, ISS, MSCI, Refinitiv, and Sustainalytics are all well-known ESG scoring and ranking organizations that analyse public data. Their criteria, which are in most cases only available by subscription, are recognized and used worldwide. Looking at these rankings reveals many points of interest, such as many cases where the companies assessed are presented on an industry-by-industry basis, facilitating relevant comparisons.

Investment service providers can also decide the evaluation criteria for the companies available through their service. They can use rankings constructed by other entities that are ideally aligned with the interests of their investors, or they can create their own. In other words, even in this segment of the market, players have a great deal of freedom in how they score companies, which can lead to further stark differences in the assessment of ESG.

From an individual’s perspective, it should be expected that while company X can be first in one ESG ranking, that same company may very well be much further down the list according to another ranking, while some personal preferences – such as diversity quotas of the management board – may not even be considered in each ESG scoring system.

Clearly, there are many issues in ESG scoring that raise additional concerns, from a regulatory, a consumer, or a transparency standpoint. In the following installments of our ESG blog series, we will try to shed light on some of these for our readers.

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