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Our guide to understanding an ESG score
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As ESG principles become mainstream in the business world, the market for ESG rating firms is experiencing rapid expansion. To navigate this evolving landscape, it's crucial to understand the nuances of an ESG score and its significance in modern investment and business decisions.
👉 What is an ESG score? Why is it important? And how can companies obtain their own ESG report?
ESG score
ESG scores provide a quantifiable measure of a company's performance in environmental, social, and governance aspects, offering investors and stakeholders a glimpse into its sustainability and ethical practices. But before delving deep into the intricacies of ESG scores, it's essential to first grasp the fundamentals of ESG itself and understand the breadth and depth of ESG reporting.
First up, what is ESG?
Let’s start with the basics - What do we mean by ESG?
ESG stands for Environmental, Social, and Governance. These are the three main pillars of ESG frameworks and represent the topics that companies are expected to report on. The purpose of this reporting is to capture the non-financial risks and opportunities associated with a company’s day-to-day operations.
👉 To learn more about ESG criteria, why not check out our article explaining everything you need to know.
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Why should companies care about ESG reporting?
“ ESG reporting is becoming increasingly important in today's business environment and is now generally considered to be an essential component of both business strategy and brand management. ”
Companies that report on ESG risks and opportunities are generally considered to be better positioned for future growth and success. This is for a number of reasons, including:
- Risk mitigation - Companies with ESG practices are better prepared to mitigate risks relating to regulation, reputation, sustainability, and social responsibility. Regulations in the area of ESG are rapidly changing and evolving, and companies that are not up to speed, or fail to comply may face legal and financial repercussions.
- Operational efficiencies and cost savings - ESG practices can help businesses eliminate operational inefficiencies and introduce more sustainable business practices, which ultimately have the potential to reduce energy usage and the cost of utilities.
- Sustainable value chains - By choosing to work with suppliers who also prioritize ESG considerations, companies can improve the sustainability of their value chain. This also helps to minimize risks associated with suppliers who are not aligned with ESG standards.
- Innovation - An ESG mindset can lead to new business opportunities and innovations. It also gives companies a competitive advantage.
- Attract investors - Investors are increasingly taking into account ESG performance when selecting potential investment opportunities. Research also shows that companies with strong ESG practices tend to perform better in the long term. Read our article to learn more about ESG investing.
- Enhanced reputation - Consumers are increasingly concerned with issues such as sustainability, which is why by adopting strong ESG practices, businesses can set themselves apart from the competition and enhance their brand image.
- Attract and retain talent - Employees (especially those from younger generations) are another group who increasingly care about environmental and social issues. So much so that this is impacting their choice of company. If businesses want to attract and retain the best talent they will need to implement strong ESG practices.
👉 For a more in-depth look at ESG reporting and its benefits, take a look at our article on the topic.
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How can companies implement ESG practices?
So how exactly does a company go about implementing ESG practices?
- Create a comprehensive ESG strategy - Companies need to start by identifying clear ESG goals for their business. This will allow them to create an ESG strategy that works for their specific business.
- Identify key ESG issues - It might be the case that some ESG considerations are more relevant to a business than others. By focusing on these, a business can maximize the impact of its ESG practices.
- Carry out regular ESG reviews - Regular ESG assessments ensure that the company is on track for meeting its ESG goals, it also helps to identify areas for improvement.
- Adopt sustainable business practices - ESG considerations ask companies to reduce their impact on the environment by adopting more sustainable business practices. This may include reducing waste, minimizing energy consumption, or sourcing more sustainable materials.
- Ensure ESG is absorbed into decision-making - ESG considerations should form part of company decision-making processes. One effective way to achieve this is to establish an ESG committee or to assign someone the responsibility of reviewing and updating ESG practices.
- Monitor and report on ESG performance - Monitoring and reporting on ESG performance is one of the most effective ways to track progress and ensure accountability. It also helps to showcase the company's transparency and commitment to ESG considerations.
How does a company report on its ESG performance?
“ ESG reporting is the disclosure of environmental, social, and corporate governance data. It demonstrates a company’s ESG commitment and provides stakeholders with an overview of the practices adopted by the company to this end. ”
While there is no universal ESG reporting standard, there is a whole range of frameworks, voluntary standards, and legislation that exist. This means that companies are afforded a lot of freedom when it comes to selecting the standard that suits them best. However, this can also make it difficult for stakeholders to understand and compare the ESG performance of different companies.
Generally speaking, ESG reports will cover a wide variety of ESG considerations, including the following.
Environmental
- How the company is tackling climate change
- How the company is reducing its greenhouse gas emissions
- What actions the company is taking to: preserve biodiversity, improve air and water quality, reduce and manage waste, etc.
- How the company ensures that its supply chain resources are sustainable
Social
- How the company protects its employees
- What inclusivity initiatives have been implemented
- How the company protects data and privacy
- How the company upholds human rights and employment standards
Governance
- What internal controls are in place to protect against corruption
- What policies and procedures exist covering board composition, executive remuneration, audit committee structure, shareholder rights, bribery, lobbying, political contributions, etc
ESG reports serve as comprehensive documentation of a company's sustainability initiatives and performance, which are then synthesized and evaluated to determine a company’s ESG score.
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What is an ESG score?
An ESG score, also referred to as an ESG rating, is an essential measurement of the environmental, social, and governance (ESG) efforts taken by a company. The ESG scoring assigns a quantitative metric (such as a numerical or alphabetical score) that allows stakeholders to compare the ESG performance of different organizations.
ESG scores are usually assigned by third-party providers and depending on the provider, different criteria may be used to score a company.
What is an ESG score used for?
An ESG score or rating not only allows a company to measure the success of its ESG practices, but is also used by investors, analysts, and a variety of other stakeholders to assess the risks and opportunities arising from a company’s business operations. It also enables stakeholders to compare an organization with competitors within the same industry or sector.
ESG scores a useful for a number of reasons:
- Validation - An ESG score is a public validation of a company’s ESG efforts.
- Competitor comparison - Investors and other stakeholders are able to compare companies based on ESG performance.
- Industry benchmarking - ESG scoring allows broader industry benchmarks to be established, and helps to understand where a company sits in the wider industry matrix.
- ESG progress - ESG scores help companies to better understand their progress against ESG goals.
- Risk identification - ESG scoring can help to identify company risks, which then allows the organization to put measures in place to deal with these risks.
- Investor comparison - Investors can compare the ESG scores of different companies, and may use this information when deciding on investment potential.
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Who provides an ESG score?
“ There are a variety of third-party providers when it comes to ESG scoring. ESG rating agencies are hired by companies to perform an in-depth analysis of their ESG practices, which then allows them to identify areas to improve on, and to implement more effective ESG policies. ”
Additionally, companies may also choose to adopt an internal scoring process based on a standardized ESG framework such as the Task Force on Climate-Related Financial Disclosures (TCFD) or the Global Reporting Initiative (GRI).
Some of the most well-known third-party providers that you’ve probably already heard of include:
- Bloomberg ESG data
- Sustainalytics ESG Risk Ratings
- Moody’s ESG Solutions Group
- FTSE Russell’s ESG Ratings
- ISS Services Ratings and Rankings
- S&P Global ESG Scores
- CDP Climate, Water, and Forest Scores
👉 To learn more about the Global Reporting Initiative and how to implement it in your own company, see our article. You can also learn more about the Task Force on Climate-Related Financial Disclosures here.
How is an ESG score calculated?
ESG scores, representing Environmental, Social, and Governance factors, are determined differently by various rating firms, each using their unique algorithms and criteria. These scores commonly stem from multiple sources including securities filings, voluntary business disclosures, governmental databases, academic research, and even media narratives.
👉 Any information that a business has made available through voluntary disclosure frameworks like the Global Reporting Initiative, the Carbon Disclosure Project (CDP), and the United Nations Sustainable Development Goals can also be used.
The data collected is segmented into scores for environmental, social, and governance criteria, which are subsequently combined into a comprehensive ESG rating.
Understanding an ESG score
While the format of ESG ratings may vary - be it a numerical score, a letter grade, or a categorical descriptor - they can generally be grouped into the following categories:
- Excellent: Companies excelling in ESG with few challenges.
- Good: Companies following ESG practices with minor negative impacts.
- Average: Companies not fully meeting ESG standards or not actively improving.
- Poor: Companies neglecting ESG considerations, these companies may be harming the environment and treating employees poorly.
ESG scores help investors understand a company's practices, from employee treatment to decision-making and environmental priorities. Companies with good ESG scores often face fewer risks, attract better talent, and maintain strong stakeholder relationships and a solid reputation. This can enhance a company's profitability in the long run.
The problem with third party ESG ratings
The ESG ratings market is rapidly growing, however, concerns have been raised over the reliability of ESG ratings and scores. With so many ESG rating firms on the market, and without any standardized ESG rating framework, how can stakeholders be sure that scores accurately reflect a company’s ESG practices?
In response to this growing concern, a number of countries and institutions are now looking into the regulation of the ESG ratings market:
UK ESG rating regulation
Third-party ESG rating firms are not directly regulated in the UK, however, this could soon be about to change. In July 2023, the UK Government announced that ESG rating firms in the UK will face a new voluntary code of conduct. This comes ahead of potential mandatory regulations for the sector.
The code covers the governance of ESG ratings firms, alongside their systems and controls. It aims to ensure that ESG ratings are accurate and that methodologies are transparent.
👉 The UK Government is currently consulting on whether or not ESG rating firms should be formally regulated. ESG rating firms in the UK can expect to see regulation within the sector expand.
US ESG rating regulation
There is currently no regulatory regime when it comes to ESG rating firms in the US, however, there are growing calls for the US Securities and Exchange Commission to regulate the sector. Critics argue that ESG ratings are not sufficiently transparent and that varying ESG criteria make comparisons between companies difficult.
👉 Even though there is no sign that the SEC will take steps to regulate ESG rating firms, the SEC has proposed rules to enhance and standardize climate-related disclosures for investors. This would mandate certain climate-related disclosures in the periodic reports of public companies.
EU ESG rating regulation
In June 2023, the European Commission published a sustainable finance package. Part of this package includes a proposal for regulation over the EU’s ESG rating activities. The proposed regulations would apply to ESG rating providers operating in the EU.
ESG rating firms that fall under the scope of the proposed regulations would be subject to authorization granted by the European Securities and Markets Authority.
The proposed regulations would improve the transparency of ESG ratings criteria and methodologies by necessitating the disclosure of such information. The regulations will also help to eliminate potential conflicts of interest and reduce instances of greenwashing.
👉 The EU’s proposal is currently going through the EU legislative procedure and will be reviewed by the European Parliament and the Council of the European Union.
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The benefits of regulating ESG ratings companies
Regulations are on the horizon for ESG rating agencies, but what does this mean for businesses? Is it a positive change?
- Unified Terminology - Despite variations across regions, new regulations aim to standardize ESG terms. This harmonization simplifies sustainability efforts and public disclosures by ensuring everyone speaks the same language.
- Greater Transparency - The push is on for clearer insights into ESG rating methodologies. With clearer regulations, businesses will better understand how to elevate their scores and where to focus efforts for better evaluations.
- Combatting Greenwashing - Regulatory oversight aims to curb exaggerated or false sustainability claims. By spotlighting genuine efforts and requiring solid proof, the regulations will prevent companies from inflating their ESG achievements.
While these regulations streamline processes for companies, they also set higher sustainability standards. However, it's a win-win. Strengthening trust in ESG ratings, which are integral to sustainable investing, is beneficial for all. The move towards clarity and against greenwashing only reinforces this trust.
What about Greenly?
At Greenly we can help you to assess your company’s carbon footprint, and then give you the tools you need to cut down on emissions. Why not request a free demo with one of our experts - no obligation or commitment required.
If reading this article has inspired you to consider your company’s own carbon footprint, Greenly can help. Learn more about Greenly’s carbon management platform here.
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