ESG ratings and how they work

How the ESG profile of companies is assessed (according to environmental, social and management criteria). What you need to know if you are considering an ESG Ranking and what to look for when preparing to receive an assessment.With the popularization of the sustainable development movement, there is a growing demand from investors for financial instruments that contribute to the development of a greener economy and to reduce the risks associated with climate change and social factors.

Capital providers are implementing the principles of sustainable financing, which means evaluating an investee against ESG criteria in order to make an investment or financing decision. The trend towards “sustainable” investment can be seen in the number of signatories of initiatives such as PRI (Principles for Responsible Investment) and PRB (Principles for Responsible Banking). The growth in the number of PRI signatories over the past 10 years has averaged 16% per year. The number of PRB signatories in 2021 increased by 30%.

At the same time, as part of the practice of "sustainable" investments, capital providers are faced with the problem of assessing the ESG profile of companies. Methods for assessing financial performance have been developed and tested for a long time, and are confirmed by the statistics of defaults and realized risks. However, the procedures for assessing environmental, social and governance performance are still new and have not yet stood the test of time.

Some investors and lenders are developing their own methods for assessing business ESG indicators. Others turn to third parties, specialized companies that assign ESG Ratings.

The ESG-Rating is an independent assessment of a company that shows the quality of its management of environmental and social issues (including personnel management, customer service, impact on communities, etc.) As a rule, this follows from our review below, ESG risks are assessed business (non-financial risks) that can harm the development of the organization in the long term. At the same time, the areas where the company has the greatest impact on the economy, ecology and society are analyzed.

This assessment is most often given by specialized rating agencies. Ratings are primarily used by investors, less commonly by lenders, to supplement their own analysis. To do this, they use not only the final assessment of the rating agency, but also the ESG data provided as part of the assessment about the company. In addition, some use several ESG ratings at once to get the whole picture. This practice is widespread, among other things, due to the problem of standardization of ratings - different agencies can assign very different ratings to the same company.

An organization that is to receive an ESG Rating should take a responsible approach to choosing a rating agency and understand its methodology, as well as carry out preparatory work in advance for obtaining an assessment - in fact, they will consist in the development of ESG practices and reporting.

What are ESG Rankings?

ESG rating is an assessment of the ESG profile of a particular organization. Evaluation criteria typically include environmental, social and governance issues. Their number can vary from several tens to several hundreds. Each criterion has its own weight in the final assessment. Therefore, the criteria can be divided into more significant (to a greater extent determining the final grade) and less significant (playing a smaller role in the rating level). The criteria for evaluating a particular company and the weight of individual criteria will be different for different companies: they vary depending on the characteristics of the organization's operating model, its industry, and the geography of operations.

There are already more than five hundred different ESG Ratings and Rankings, and they differ in their assessment approaches and methodologies. Research Affiliates , for example, divides agencies into three groups [4]:

Data providers are organizations that specialize in collecting company ESG metrics. They do not have an ESG profile assessment methodology as such and work with publicly available company data (examples are Bloomberg, Refinitiv).

Comprehensive ESG-rating - agencies that have their own methodology for a comprehensive assessment of a company in terms of environmental, social and management indicators. The assessment includes analysis of both publicly available data and data provided directly by companies upon request. Agencies that assign these ESG Ratings include traditional rating agencies that have previously worked with credit ratings (for example, S&P Global and Moody's), and "new" agencies that specialize specifically in sustainable development (MSCI, Sustainalytics, RepRisk, and etc.).

Specialized ratings are agencies that evaluate only individual sustainability topics and do not claim to evaluate a comprehensive profile of ESG. For example, the CDP (Carbon Disclosure Project) specializes in environmental topics such as climate change, the protection of forests and water resources.

With the development of data processing technologies, a trend has begun to expand their use among rating agencies that assign ESG Ratings. Some agencies, in an effort to improve the quality of the data they collect and reach, are starting to implement artificial intelligence (AI), machine learning (ML), etc. One such agency is RepRisk, which uses AI and ML to analyze data. MSCI and Sustainalytics also use AI and other technologies to ensure data accuracy and analysis, and to monitor news and other sources in large datasets. Moreover, Moody's has developed a unique ESG Score Predictor model that uses machine learning and a database of thousands of companies to calculate the ESG score and obtain predictive scores for any firm.