Insight

ESG ratings: A tool for companies as well as investors

By Faith Nicholas

Many of our clients express frustration with the flood of third-party ESG rankings, ratings, and questionnaires that come across their desks. The number of ESG ratings and rankings evaluating company ESG performance has ballooned over the past ten years, with an estimated 600 products now available. With all these frameworks measuring different things and coming to different conclusions, how can a company know where to start?

The trick is to think of ESG ratings not as the ultimate gauge of ESG performance, but as another tool ESG professionals can use to refine and improve their strategy, performance, and disclosures around ESG issues.

Why companies should pay attention to ratings

The proliferation and importance of ESG ratings is driven largely by investor demand for ESG data. Investors are increasingly incorporating ESG data into investment decisions and creating financial products to appeal to customers—who, increasingly, want their investments to align with their values.

Since ESG data is not regulated in the same way financial data is, investors must rely on whatever companies decide to disclose—which is often inconsistent across an industry and of questionable origin. Enter ESG ratings. Ratings aggregate these diffuse and inconsistent corporate data, attempt to standardize performance across an industry by assessing all companies on the same criteria, and provide this information to investors.

ESG ratings are not, however, a perfect solution to investor appetite for ESG data. The shortcomings of ratings are well-documented: conflicting scores, industry classification, missed disclosures, etc. Large, sophisticated investors are aware of these problems, however, and most use ratings simply as indicators of risk or outperformance and rely on internal research and analysis to inform their own conclusions. Additionally, investors are beginning to purchase the underlying data separate from the ratings to supplement their own research.

A measured review of ratings

Despite their shortcomings, ESG ratings can still be valuable inputs to a company’s ESG function. In the same way most investors use ratings as a signal, ratings can help a company quickly understand external perceptions of their strengths and weakness. Ratings can also be a strategic internal benchmarking tool to guide decision-making and improve ESG performance. And although ratings do influence investors to varying degrees, and a poor rating can lead to a loss of capital in extreme situations, they more often will offer opportunities for engagement around those issues of concern. Finally, ratings can also provide the validation internal advocates need to promote change in their organization.

We recommend our clients use several lenses in understanding and using ratings to inform internal decisions around disclosure and strategy. To get started, companies can ask the following questions:

  • Which ratings are most important to our company?

    Since a company may have limited resources to devote to ESG ratings, it can be useful to identify a handful of ratings that are most relevant to the company. While companies should consider the reputation and popularity of a rating, this need not be the only determining factor. Companies can and should also review the industry classification and material issues in a rating report, to see if the rater’s perspective of the company aligns with the company’s perspective. Companies may also benefit from engaging with their top investors to better understand which ratings they use. See our brief, Making sense of ESG ratings and rankings, for more detail on individual ratings and methodology.

  • Which issues have the highest weight and are most common across ratings?

    Raters assign different weights to issues, depending on their relevance to the company. Companies should review which issues are contributing the most to their rating, as well as collect the issues that are most prevalent across several important ratings. This exercise will help a company better understand which issues the financial community has identified as material for the industry, allowing a company to focus disclosures in these areas.

  • Where can the company improve?

    Companies may perform well on the issues deemed most material to the industry but lack other table-stakes disclosures. Companies can benefit from reviewing areas with the largest gaps in performance. This exercise can also help identify “low-hanging fruit”, which may not be worth a lot of “points” but can be relatively easy to address and provide a quick boost to a company’s rating.

Often, the responses to these questions reveal that ratings do not provide a complete portrait of a company’s ESG performance but rather are one input to consider in a company’s sustainability strategy. Companies can take a cue from investors and use ESG ratings as one tool in the sustainability toolbox.

We at FrameworkESG help our clients understand ESG ratings in the broader context of all stakeholder expectations and make a plan that addresses both the gaps identified in ratings and the goals of the company. We help our clients understand how ratings work and how investors use ratings, so they can review ratings reports from an informed perspective. For more information on how we can help, contact Victor Melendez, Managing Director & Chief Growth Officer.