An ESG rating measures a company's exposure to long-term environmental, social, and governance risks. These risks -- involving issues such as energy efficiency, worker safety, and board independence -- have financial implications. But they are often not highlighted during traditional financial reviews. Investors who use ESG ratings to supplement financial analysis can gain a broader view of a company's long-term potential.
Here's a closer look at ESG ratings, including how companies are scored and how these ratings affect you and your portfolio.
What does an ESG rating mean?
A good ESG rating means a company is managing its environment, social, and governance risks well relative to its peers. A poor ESG rating is the opposite -- the company has relatively higher unmanaged exposure to ESG risks.
Along with ESG reporting, ESG ratings help investors understand a company's priorities and the long-term risks it could face in the future.
One of the most widely referenced ESG rating systems is the MSCI ESG score. MSCI scores roughly 8,500 companies and more than 680,000 fixed-income and equity securities globally, including ESG funds.
The foundation of the MSCI ESG score is a key issues framework that measures risk across 10 categories of environment, social, and governance areas.
Considerations for the environmental score
MSCI's key environmental issues fall under the categories of climate change, natural capital, pollution and waste, and environmental opportunities.
Climate change issues include:
- Carbon emissions.
- Product carbon footprint.
- Financing environmental impact.
- Climate change vulnerability.
Natural capital issues are:
- Water stress.
- Biodiversity and land use.
- Raw material sourcing.
The pollution and waste category encompasses:
- Toxic emissions and waste.
- Packaging material and waste.
- Electronic waste.
Environmental opportunities are:
- Clean technology.
- Green building.
- Renewable energy.
How are companies scored?
- Key issues are identified by industry. MSCI selects 33 of the most relevant issues to specific industries. For example, packaging material and waste are key issues for the soft drink industry. This wouldn't be a factor for industries that don't physically package a product, such as technology infrastructure. Corporate governance key issues are included for all industries.
- Companies are scored on each key issue. MSCI analyzes 80 different exposure metrics and 270 governance metrics to score companies from 0 to 10 on each key issue. A low score means the company is heavily exposed to the issue and is not managing that risk effectively. A high score indicates an aggressive effort to mitigate the risk. An example of risk mitigation for carbon emissions would be Microsoft's (MSFT +0.57%) goal to become carbon-negative by 2030.
- Issues are weighted. MSCI weights key issues according to their timeline and potential impact. Issues that could have a major environmental or social impact within two years have the highest weight. Issues with lesser potential for impact and a timeline of more than five years have the lowest weight. Worker safety in a manufacturing environment, for example, presents an immediate risk with severe financial and legal consequences. That would justify a heavier weighting.
- Issue scores and weights are combined. Issue scores and weights are combined to produce an industry-adjusted numerical score from 0 to 10 for the rated company.
MSCI translates the numerical score into an ESG rating. ESG ratings range from CCC to AAA. The leaders have AA and AAA scores. As shown in the table below, the ratings are also grouped into three segments: laggard, average, and leader.
Comparative Performance | ESG Rating | Numerical Score |
|---|---|---|
Leader | AAA | 8.571-10.000 |
Leader | AA | 7.143-8.571 |
Average | A | 5.714-7.143 |
Average | BBB | 4.286-5.714 |
Average | BB | 2.857-4.286 |
Laggard | B | 1.429-2.857 |
Laggard | CCC | 0.000-1.429 |
ESG ratings for more informed investing decisions
The best ESG stocks in 2022 and the six best ESG ETFs put together companies that have sustainable business practices and deliver outstanding financial returns. You don't have to be committed to sustainable investing to value the role ESG review plays in the investment process.
Institutional Investor
ESG scores help you find lower-risk, higher-return stocks, and that's an outcome most investors, from institutional investors to retirement savers, can appreciate.
About the Author
