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From AAA to ZERO: Understanding ESG Ratings and Rankings

In March, the ESG investing landscape experienced a seismic shift. The United States Securities and Exchange Commission (SEC) released its proposal for America’s first standardized environmental sustainability risk disclosures and mandatory carbon emissions reporting.

Global ESG assets under management are predicted to reach $53 trillion by 2025 (Bloomberg, Bloomberg Intelligence 2021). With this much at stake, investors, asset managers and companies are pressuring the SEC to adopt universal ESG reporting standards. The recent SEC vote follows Europe’s Sustainable Finance Disclosure Regulation (SFDR) passed in March 2021, creating transparency for investors by requiring companies to substantiate sustainability claims with transparent, consistent, and comparable data.

The SEC’s proposal would require publicly traded U.S. companies to disclose (by 2023, 2024, or 2025 depending on size):

  1. Scope 1 and 2 emissions, meaning greenhouse gases created from the purchase and direct use of energy
  2. Scope 3 emissions (generated through company purchases, services, and sales) as reduction targets are announced or when those emissions pose a financial risk

Although the SEC will define required disclosures and regulate the way corporations measure and report on specific climate and social risks, it will not play a role in comparing corporate data. This means investors and asset managers will continue to utilize ESG scores to evaluate sustainability claims and ESG investment risks.

Which ESG scores should companies and investors focus on?

ESG risks and achievements are inherently challenging to quantify. In general, ESG ratings predict a company’s exposure to long-term environmental, social, and governance risks. With more than 600 ESG ratings and rankings impacting billions of dollars of investments each year, it may be surprising to learn that most do not measure tangible positive or negative impacts; they primarily compare and rank companies on financial risks associated with ESG issues.

Scores, rankings, and indices provide insights about a company’s resilience to climate change and weather disruptions, whether policy and oversight systems are structured to avoid bribery, human rights and corruption scandals, and how the business is positioned reputationally around matters of diverse leadership and executive compensation.

Each rater or ranker gathers information about a company’s operations and risks and employs a proprietary weighting system to calculate individual scores. Most publish their key areas of review (closely related to each company’s material disclosures), but the final mathematical formula is generally sealed under lock and key and evolves each year. Raters also use unique data collection strategies and evaluate information through their own, individual risk-analysis lens. Widely used ratings have built credibility by gathering trustworthy data and verifying their findings with company representatives. Others take advantage of advances in machine learning and artificial intelligence to mine data from websites and publicly available sustainability reports.

Different motivations and collection methodologies mean scores can diverge widely across ranking systems. For example Tesla receives an A from MSCI and a perfect 10/10 from ISS, but a low 28.5/100 from Sustainalytics and only 28/100 from S&P Global (specific ratings are explained below). This can lead to frustration for investment professionals. The ratings approaches won’t change anytime soon. However, the availability of reliable data points will improve significantly under the SEC’s proposal. ESG analysts and data scientists will be quickly evaluating the SEC’s new disclosure requirements and updating their methodologies to incorporate this soon-to-be-available treasure trove of public information. Sector-specific compliance reports will improve scoring reliability as companies begin to release transparent and comparable disclosures. A successful new SEC-driven regulatory framework, creates the possibility of coalescing scores, perhaps similar to the debt rating framework (including major players like S&P and Moody’s).

Investors tend to use ESG ratings at least once per week and rely on multiple scores (Investor Insights, Rate the Raters 2020). Larger asset managers, on the other hand, use ratings as a starting point and develop additional internal ESG screening systems to build their investment portfolios.  At Focus Impact, we reference several of the ratings and rankings referenced below, and also screen for strong alignment with the United Nations Sustainable Development Goals of Good Health and Well Being, Gender Equality, Decent Work and Economic Growth, and Reduced Inequalities.

A Deeper Dive into Ratings & Rankings

The most widely used ratings employ experienced research teams, have a reputation for strong data quality and ranking methodology, and report on a large number of companies. Many rankings and indices focus on a single element of environmental, social or governance risk analysis. The two most highly-referenced raters, Sustainalytics and MSCI, review a wide range of ESG dimensions to create a blended score. Below, we’ll review several predominant ESG raters, lists and indices, and then reveal their scores in action for three popular publicly traded companies.

BLENDED SCORE ESG RATINGS

Sustainalytics

Morningstar’s Sustainalytics rates a company’s exposure to, and management of 20 financially-material ESG issues using a quantitative score and a risk ranking. A corporate governance analysis is then integrated into the final rating. Sustainalytics compares more than 13,000 publicly traded companies around the globe annually and uses only company-verified data. Companies are benchmarked against all industry peers included in that year’s review.

Key measures include:

  • Carbon as an impact of product and service use + GHG emissions
  • Human Rights
  • Data Privacy & Security (an increasingly important component of Social metrics)
  • Business Ethics and Bribery & Corruption
  • Health & Safety
  • Community Relations

MSCI

Morgan Stanley Capital International (MSCI) develops scores based on both risk exposure and management metrics for 35 key ESG issues. Scores reflect how well companies manage risks relative to peers and range from leader (AAA, AA) to laggard (B, CCC) through a letter grade. MSCI compares more than 14,000 publicly traded companies each year using verified data. They also provide forward-facing data on projected temperature trajectories, and whether a company is on track to meet global climate goals.

Key measures include:

  • Climate Change and Natural Capital
  • Environmental Opportunities
  • Human Capital
  • Product Liability
  • Corporate Governance
  • Corporate Behavior (including Ethics and Tax Transparency)

S&P GLOBAL ESG INDICES

S&P rates more than 10,000 companies annually through a 450-question Corporate Sustainability Assessment. The indices use S&P DJI ESG Scores to select constituents and benchmark each company’s ESG strategy and ability to prepare for potential future risks and opportunities. Questions and weightings are industry-specific and contribute toward a company’s percentile score, with 1 being the worst and 100 being the best. North American participation nearly tripled over the past five years.

Key measures include:

  • Corporate Governance
  • Codes of Business Conduct
  • Risk & Crisis Management
  • Operational Eco-efficiency and Water Risk
  • Information Security
  • Talent Attraction & Retention and Human Capital Development 

REPRISK

RepRisk is a database of more than 170,000 companies, including privately held entities and is updated daily. RepRisk relies on machine learning and artificial intelligence to screen unverified data, and scores are only available through a paid subscription.

ENVIRONMENTAL SUSTAINABILITY RATINGS

The Carbon Disclosure Project, known as CDP, is a not-for-profit rating system that evaluates an entity’s projected ability to measure and manage climate change, water security and deforestation risks and opportunities. CDP reviews 9,000 publicly traded companies (and municipalities) each year and all data is verified by company representatives.

SOCIAL SUSTAINABILITY RATINGS

Human Rights Campaign’s Corporate Equality Index rates companies on demonstrated equality and inclusion for LBGTQ+ employees.

World Benchmarking Alliance produces the widely-referenced Corporate Human Rights Benchmark rating global Automotive, Apparel, Agricultural, ITC and Extractive sector companies.

Bloomberg’s Gender Equality Index includes 418 companies excelling in five areas: female leadership and talent pipeline, equal pay and gender pay parity, inclusive culture, anti-sexual harassment policies, and pro-women brand.

GOVERNANCE RATINGS

Institutional Shareholder Services group of companies (ISS) measures a variety of ESG risk factors, and is most well-known for their QualityScore governance insights, gleaned by following 48,000 shareholder meetings in 115 markets.

Ethisphere produced a 2022 list of 136 organizations they deemed as having an unwavering commitment to business integrity.

Refinitiv has a database of more than 9,000 public companies using verified data. Refinitiv is unique in that it updates scores from 0-100 on a weekly basis. They also produce the Corporate Governance Top 100 list.

Scores in Action

Several luminary companies such as Salesforce, Best Buy and L’Oreal score well across multiple ratings frameworks. Their ratings are reviewed below, alongside considerations of how their commitments, operations and activities contribute to high scores. Specific companies are listed for demonstration purposes only, and not intended as investment advice.

 

SALESFORCE (NYSE:CRM)
Salesforce founded Pledge 1%, committing 1% of their profit, product, and time to improving education, equality and the environment. The company has achieved net-zero carbon emissions across its value chain and uses 100% renewable energy for its operations. They also established a racial equality and justice task force resulting in $16 million for equal pay initiatives.

 

MSCI AA Driving this score are measures under Human Capital Development and Privacy and Data Security, as well as ‘on track’ climate goals
Sustainalytics 13.2 Low Risk (21 out of 995 Software Companies) Scored well (low risk, strong management of material issues) on Corporate Governance, Human Capital, Data Privacy & Security, and low controversy risk
S&P Global 48 out of 100
Carbon Disclosure Project A on Climate
Human Rights Campaign “Best Places to Work”

 

BEST BUY CO (NYSE:BBY)
Best Buy is a founding member of the Race to Zero campaign, accelerating climate action in the retail landscape. In 2021, they achieved 100% waste diversion, keeping all solid waste out of landfills – even gift cards are recyclable. The company committed $10 million toward Best Buy’s Teen Tech Center programs across the country, where young people from disinvested communities learn about programming, design, and music production. 

 

MSCI AAA
Sustainalytics 14.3 Low Risk (102 out of 449 retailers) Scored well (low risk, and average management of material issues) on Corporate Governance, Human Capital, Human Rights in the Supply Chain, as well as low-to-moderate controversy risk
S&P Global 55 out of 100
Carbon Disclosure Project A on Climate
Human Rights Campaign “Best Places to Work”

 

L’OREAL (OR:EN Paris)
In 2020, 96% of L’Oréal’s new or renovated products had an improved environmental and social profile. That same year, the company helped 100,905 people from disadvantaged communities find employment through its solidarity purchasing and inclusion programs.

 

MSCI AAA High scores for corporate behavior, packaging and waste, health and nutrition opportunities
Sustainalytics 17.1 Low Risk (2 out of 101 household products companies) Scored well (medium exposure and strong management of ESG risk) on Corporate Governance, Human Rights in the Supply Chain and Environmental & Social Impact of Products & Services, as well as a low-to-moderate controversy risk
Carbon Disclosure Project A on Climate Change, A on Forests and A on Water
Human Rights Campaign “Best Places to Work”

Shifting the Ratings Lens

ESG scores are valuable peer-to-peer company comparison tools, especially for risk evaluation. However, the most popular ratings systems are not necessarily reliable indicators of positive impact or values alignment. Companies boasting high ESG scores may be working against socially conscious investment objectives. Examples of this include fossil fuel and tobacco giants that may demonstrate sector leadership around climate risk mitigation or supply chain management. Both activities strengthen ESG scores. MSCI rates Exxon as BBB (high average) and CDP awards Philip Morris an A for Climate. However, Exxon’s revenues are dependent upon the extraction of limited natural resources and their core product emits harmful greenhouse gases. Philip Morris’ products are associated with cardiovascular disease and premature death. 

Established raters are beginning to add value to their scores by including the business’ opportunity to contribute to a healthier planet and a more just society. These future-oriented scores can help ratings agencies differentiate their product offerings. While investment goals always include financial returns, there are now many options to simultaneously increase long-term risk reduction for our global society. 

Focus Impact looks beyond the standard ratings systems to make thoughtful, targeted investments in high-growth “Social Forward” companies. Social Forward businesses deliver double-bottom line results through meaningful, measurable social outcomes and superior, risk-adjusted returns. Focus Impact is committed to amplifying companies that demonstrate this critical alignment of shareholder and social value. 

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Investor Insights, Rate the Raters 2020
ISSB Working Group Climate-related Disclosures Prototype, November 2021
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