What are ESG scores and ratings?
The use of ESG ratings and scores in the investment industry has grown rapidly in the past decade or so, amid growing scrutiny of corporate environmental, social and governance performance, and of sustainability-related claims. The ESG rating sector is thus gaining influence, with projections that USD33.9 trillion of global assets under management will consider ESG factors by 2026. As the sources and volume of ESG data multiply — and its reliability becomes more critical — regulators are responding by drafting rules to improve transparency in this area.
This article outlines the purpose of ESG scores and ratings, who uses them, who calculates them (and how), the challenges they present, and how investors and other stakeholders are addressing these issues.
What are ESG scores and ratings designed to do?
Scoring companies on their environmental, social, and governance performance has become an increasingly common investment practice. But what are ESG scores, and how do ESG ratings differ?
ESG scores vs ESG ratings
The terms are often used interchangeably: ESG scores usually provide a numerical value (typically 1 to 10, or 1 to 100) while ESG ratings are typically letter-based grades. Both aim to assess companies’ performance in respect of environmental, social, and governance factors. A company will typically receive an overall ESG rating or score as well as more granular ones for different categories.
These ratings are predicated on the notion that companies with better scores will exhibit better financial performance over time because they face lower ESG risks, and are more adept at managing them, or some combination thereof, as a CFA Institute blogsuggests.
While that is a contentious subject for some investors, academic research tends to suggest that sustainability-focused investment improves returns over the long term (See Figure 1).
Who uses ESG scores and ratings, and why?
nstitutional investors — and asset managers acting on their behalf — use ESG ratings and scores to help them make allocation decisions aligned with their values, risk management goals, and long-term performance objectives.
Other financial institutions, such as banks and insurers, also consider these metrics. The former typically do so as part of their risk assessment process when making loans, and the latter to understand better their corporate policyholders' operational management and risk profiles.
Some lenders may offer companies lower interest rates on financing in return for improved ESG performance — and similar benefits may be available in the bond market, through green, social, or sustainability-linked debt.
How are ESG scores and ratings calculated?
ESG rating methodologies can vary widely across providers. Typically, ratings are calculated using a combination of:
- Quantitative data, such as company disclosures and publicly available reports
- Qualitative analysis, where analysts assess governance structures, environmental policies, and social initiatives
The data is typically assigned to various categories and a separate score produced for performance in each of the three categories, and then overall for the company.
Who produces ESG scores and ratings?
The biggest providers tend to be well-established credit rating, index, or analytics companies. The number of services on offer has ballooned in what has so far been an unregulated market, but that is set to change with the introduction of regulatory requirements in markets like the EU and UK. These efforts broadly aim to improve the reliability of ESG data and transparency of how it is produced.
What are the main issues with ESG scores and ratings?
Various concerns have emerged over the practice of ESG scoring, including:
- Over-reliance on ESG ratings as green or sustainability credentials, when they actually tend to focus on how companies manage their internal processes, rather than on the real-world impacts of those companies’ products and services;
- Inconsistency between providers: the weight given to various individual ESG factors can lead to wide variations between the scores and ratings from different ESG data providers, making it hard to compare them directly across individual companies or between sectors;
- Availability of data may lead to inherent biases in the scores, with larger companies tending to score better than smaller companies, especially in emerging markets.
- Conflicts of interest for index providers that sell ESG rating services, with research showing that raters with strong index licensing incentives issue higher ESG ratings for firms with better stock return performance and those added to their ESG indexes, compared to raters with weaker licensing incentives.
These issues can make it difficult for investors to compare ESG performance reliably across sectors or markets.
ESG comparison: Correlations
| MSCI | S&P | Sustainalytics | CDP | ISS | Bloomberg | |
| MSCI | 35.7% | 35.1% | 16.3% | 33.0% | 37.4% | |
| S&P | 35.7% | 64.5% | 35.0% | 13.9% | 74.7% | |
| Sustainalytics | 35.1% | 64.5% | 29.3% | 21.7% | 58.4% | |
| CDP | 16.3% | 35.0% | 29.3% | 7.0% | 44.1% | |
| ISS | 33.0% | 13.9% | 21.7% | 7.0% | 21.3% | |
| Bloomberg | 37.4% | 74.4% | 58.4% | 44.1% | 21.3% |
Source: CFA Institute, Enterprising Investor, ESG Ratings: Navigating Through the Haze, August 2021
Why do ESG rating methodologies vary so widely?
It’s generally accepted that different ESG ratings can tell vastly different stories about the same company. But this demonstrates the immaturity of the current rating environment and highlights the need for improvements, said a CFA Institute report in 2021. A CFA Institute study, also from 2021, found that companies with high disagreement in their ratings face higher risk premiums but better stock returns.
How are investors addressing ESG scoring issues?
Investors are responding in several ways:
- Pushing for improved data disclosure from companies to reduce inconsistencies.
- Engaging directly with issuers to validate and understand ESG performance.
- Using technology, including AI and advanced analytics, to assess ESG data independently.
These efforts, combined with emerging regulatory frameworks, aim to make ESG scores and ratings more transparent, comparable, and meaningful.
Continue your journey
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