Making sense of ESG ratings

To understand what ESG ratings are, and why investors use them, you must first understand what ESG ratings are not. Here’s what you need to know.

With a single metric, ESG ratings measure the non-financial ESG risks and opportunities a company bears over the short, medium, and long term. A company’s ESG rating might account for factors like water sourcing and carbon emissions, labor management, and business ethics or board diversity and independence. Scores are often tabulated using data from a myriad of sources, including but not limited to securities filings, voluntary business disclosures, governmental databases, academic research, and media reports.

ESG ratings can provide a comprehensive picture of an organization’s environmental footprint, community investments, and regulatory dealings, but the rating systems can vary greatly. ESG ratings come from third-party organizations specializing in scoring, meaning each agency can outline its own criteria for assessing ESG performance. With hundreds of rating agencies offering their own scores, it can be challenging to decipher what ESG ratings mean for potential investments. Let’s dig a little deeper.  

A close look at ESG ratings

While there are a variety of ESG ratings in use, some are more popular than others. Here, we’ll look at the Morgan Stanley Capital International (MSCI) system, one of the leading ESG rating agencies, to better understand how an agency evaluates a company’s management of material ESG risks and opportunities.

MSCI applies a rules-based methodology to separate an industry's leaders from its laggards. To calculate a company’s final rating, MSCI analyzes its relative exposure to ESG risks and assesses how well it manages them compared to its competitors. MSCI’s ESG rating scale ranges from “leaders” (AAA, AA) at the top end, to “average” (A, BBB, BB) companies, all the way down to companies making slower progress (B, CCC).

Companies classified as leaders proactively manage the most significant ESG risks in their respective industries and take advantage of ESG-related opportunities. Companies that fall into the average category usually maintain a mixed track record, while companies with high exposure that fail to manage their ESG risks effectively fall into the laggard category.

MSCI, like all other ESG rating agencies, identifies subcategories across each important ESG issue, weighting each issue based on its timeliness and probable impact. Issues given the most significant weights have the greatest potential for impact — measured within two years — while lower weights are given to issues not projected to play out for the next five years.

Companies with high ESG scores present attractive buying opportunities for ESG-minded investors. Why? These companies are well-protected against potential risks associated with air pollution, employee dissatisfaction, growing energy use, substandard corporate governance, and more.

Common myths about ESG ratings (and why they aren’t true!)

One of the biggest misconceptions surrounding ESG ratings is what they measure. ESG ratings measure a company’s exposure to long-term ESG risks, as well as its relative ability to capitalize on opportunities driving value in the ESG space. ESG ratings are not, necessarily, a bottom-line calculation of a company’s ESG impact. They do, however, measure the environmental, social, and governance risks pertaining to a company and its shareholders, not the dangers posed to people or the planet. 

Another big myth is that ESG ratings mirror credit ratings. ESG ratings have been used for a far shorter time than, for example, traditional credit ratings. As a result, there remains far less standardization across ESG ratings — and how they’re calculated — compared to credit ratings.

Agencies that specialize in ESG ratings also weigh issues and rate risks differently. Companies usually have a wider spread of ESG ratings relative to their credit scores.¹ Since agencies use different KPIs and might deem certain risks more or less material than others, a lack of standardization across ESG agencies means greater subjectivity across ratings.

A final word on ESG ratings

Despite their limitations, ESG ratings go beyond the balance sheet to gauge how well ESG considerations factor into an institution’s corporate strategies. They often capture the value of stakeholder relationships, brand reputation, and liability exposure, all of which has the potential to materially impact a company’s profitability and bottom line.

However, a lack of unified rules and transparency surrounding ESG reporting criteria means ESG ratings only make up one piece of the puzzle. In the United States, ESG disclosures remain voluntary because Congress and regulatory bodies like the SEC haven’t yet codified any disclosure rules and requirements. For investors to draw maximum utility from ESG ratings, there must be more transparency across industries. Without unified rules and industry-wide consensus, it might prove difficult for investors to parse out an ESG rating and understand how particular ESG ratings are calculated and applied.

At AXA IM, we choose to disclose; for example, we share an Azure report for every product, which helps our portfolio managers handle ESG-integrated funds. It’s our job to educate our clients, investors, and data providers about AXA IM’s ESG policies and outlook. We also stay in touch with our data providers, including MSCI and others, and stay updated on how they use any information AXA IM discloses. Complete and total transparency is our number one priority.

Contact our global team today to learn more about AXA IM’s ESG disclosures, ESG best practices, or our corporate sustainability strategies.