Why are ESG scores important to companies?

ESG scores can aid with overall corporate governance and company management, and are important to companies for the following reasons:

• Validation. ESG scores provide a way for an organization to validate its ESG-related efforts. The score provides a publicly disclosed metric based on the organization's initiatives.
• Peer comparison. ESG scores let organizations and their investors compare one company against another.
• Benchmarking. Beyond comparing vendors, an ESG score can enable broader industry benchmarking to understand how a specific industry vertical scores and where different companies fall within the results.
• Managing progress. With a specific ESG score in hand, an individual company can better manage and measure progress using a quantitative metric.
• Investor attraction. An ESG score provides investors with an attribute that can help them make ethical, sustainable investing decisions.
• Risk management. An ESG score can help identify areas of potential concern and risk from an ESG perspective.

Who calculates and provides ESG scores?

The business of calculating ESG scores is a complex one with multiple third-party providers offering services. It's also possible for organizations to have an internal scoring process that uses a standardized framework such as the Global Reporting Initiative (GRI) or the Task Force on Climate-Related Financial Disclosures (TCFD), as well as self-analysis. The factors in an internal scoring process can mimic those executed by third-party vendors, including data collection on ESG goals and a numerical score or letter grade given for progress toward the goal.

Among the most well-known vendors of ESG scores and ratings are the following:

• Bloomberg ESG Data. Bloomberg's scoring comes from a combination of its own direct sources, as well as data from MSCI and Sustainalytics.
• Fitch Ratings. Using its own proprietary scoring system, the Fitch Ratings approach ties an ESG score to credit rating decisions.
• ISS ESG. Institutional Shareholder Services (ISS) provides insight into the financial material information that can be contained in what is normally nonfinancial ESG disclosures.
• MSCI. The MSCI ESG Ratings use a rules-based methodology that identifies the key issues, risks and opportunities facing an organization within the context of its industry vertical. MSCI is one of the most widely used vendors for ESG scores, claiming to rate approximately 8,500 corporations.
• Moody's. Formerly known as Vigeo Eiris, the Moody's ESG service provides scores and assessment of ESG initiatives. Moody's is well known in the financial services market for its bond rating services.
• Refinitiv. Refinitiv has its roots in Thomson Reuters ESG Scores and provides environmental, social and governance scores for global firms based on publicly reported data.
• RepRisk. Using a combination of machine learning and human analysts, RepRisk claims it can help to identify and classify ESG risk as part of its scoring approach.
• S&P Global Corporate Sustainability Assessment. The CSA evaluates firms by using surveys that include a blend of 80 to 100 questions that pertain to both cross-industry and industry-specific topics. Information from the CSA flows into the Dow Jones Sustainability Index family, which provides a ranking of ESG scores.
• Sustainalytics. The Sustainalytics approach looks to provide a score based on understanding an organization's unmanaged ESG risk. A key part of the score is providing insight into what the company refers to as material ESG issues (MEIs).

How are ESG scores calculated?

The specific calculation of an ESG score can vary, based on the vendor doing the scoring. Many vendors will have their own criteria and use various proprietary algorithms to reach a final score.

Though each service can have unique attributes, it's also possible to generalize the basic approach that most vendors take to calculating the ESG score.

The first stage is data collection, which is all about trying to get as much information as possible about an organization's ESG efforts. That includes data collection across environmental, sustainability, social and governance practices. Depending on the vendor, that data can come from publicly available sources, including ESG reports, media reports and academic research. Data is often assembled with the guidance of an ESG reporting framework, such as the GRI or TCFD. The data can also come from specific interviews and analysis done directly with the company being scored.

With all the data collected, the next step is the analysis of how to assign a weight or value to each entry. The scoring agency will use any number of different data points related to ESG issues the data presents. MSCI, for example, assigns a score from 0 to 10 based on an issue's timeliness and probable impact. The weights assigned to each issue are based on their potential impact within a two-year timeline, with higher weights assigned to issues with a greater potential for impact. After assigning percentage weights to ESG risks, companies are compared to others in the same industry and a final rating is determined.

The final rating can be a numerical score that can also have a qualitative term. In the case of MSCI ESG Ratings, companies can be graded as the following:

• Leader. This rating has scores ranging from 5.714 to 10.000, and letter scores of AA to AAA.
• Average. This rating has a range of 2.857 to 5.713, and a letter score of BB, BBB or A.
• Laggard. On the MSCI scale, this is a numerical score of less than 2.856 and a letter score of CCC or B.

Potential limitations and issues with ESG scores

There are a series of potential limitations and issues with ESG scores that individuals, organizations and investors should be aware of.

• Lack of standardization. Perhaps the biggest single issue is that there's no single industry standard for scoring. There isn't even a single industry framework for reporting, which is often the basis for figuring out the score. The lack of standardization makes comparisons across different scoring methodologies difficult and can potentially lead to an organization getting a higher score on one vendor scoring mechanism than another.
• Self-reported data. Though organizations can choose to use an established ESG reporting framework, the data is often self-reported by company management. Without the validation of a third-party auditor, there's a risk the data can be subjective, skewed in some way and potentially inaccurate.
• Greenwashing. On the environmental side of ESG scores, there can be a risk of greenwashing in which organizations make green claims that can potentially influence a score without making a material impact.
• Transparency. There's generally a lack of transparency when it comes to the actual weighting and calculations of ESG scores. While there's a general understanding of how the scores are calculated, few if any firms provide full transparency into the calculations.
• Scope. ESG can cover a lot of ground across environmental, sustainability and corporate governance topics. An ESG score might not have the scope or comprehensiveness to cover everything that might be applicable to a complete ESG picture.