SASB: Everything you need to know about the sustainability standards

The ESG Rating is an essential tool that helps measure and qualify companies’ sustainability. But, what does this rating actually imply and how does it affect companies as a whole?

This article explores the universe of the ESG Rating, a metric that has transformed the way in which investors, consumers and society in general evaluate corporations. 

From environmental aspects to social responsibility and corporate governance, we see how this integral barometer highlights how companies look beyond economic success, enforcing operations on a responsible and sustainable scale. 

Keep reading to understand how organisations are qualified by their sustainability, exploring common criteria, evaluation methodologies and the implications of these qualifications in the business world. We will analyse diverse categories of ESG indexes and we will figure out the challenges and limitations of these evaluations.

Defining the ESG Rating and its Importance for the Business Landscape

At the heart of sustainable corporate investment and management lies the ESG Rating, an indicator that has become of significant relevance in previous years. The abbreviation ESG represents “Environmental, Social and Governance”. This rating evaluates how a company operates and behaves in these three fundamental areas, providing as such a measurement for the company’s sustainable performance. 

What is the ESG Rating?

The ESG Rating or score isn’t just simply a check of good corporate practices; it’s an exhaustive evaluation looking at a company’s environmental management, the ethics behind their governance and social commitment. 

• From an environmental perspective, it considers factors including carbon emissions, waste management or the use of sustainable resources.
• In the social environment, elements such as just labour practices, diversity and inclusion are valued, as well as relationships with local communities. 
• Finally, governance refers to a company’s transparency, the ethics of their management and leadership structure. 

The ESG score, assigned by specialised agencies, varies given the methodology used, but in general, a high score indicates a company managing risks well in relation to the given aspects and is operating sustainably and responsibly. 

Why is an ESG Rating important?

The importance of an ESG Rating is rooted in its capacity to provide a clear perspective on how a company not only contributes to the economy, but also how it’s impacting the planet and society. 

Investors use these scores to identify companies that are profitable, but also responsible with the environment, careful with communities and well governed. 

Companies with high ESG Ratings are usually seen as less risky and more prepared for the future. 

Furthermore, these companies frequently enjoy a better reputation, which can translate to greater loyalty from clients and stronger attraction for talent in search of employers aligned with their personal values. 

ESG Rating Methodologies and Categories

Within the evaluation of sustainable business, the ESG rating is highlighted for its complexity and depth. 

This qualification system is based on a uniform methodology that extends across diverse categories and index types, every one with its specific criteria and focus. To understand this universe better, it’s essential to explore both ESG index categories as well as the underlying methodologies behind the calculations.

Types and Categories of ESG Indexes

The ESG index categories can be, for the most part, qualified into three types: exclusion indexes, ESG score based indexes and impact indexes.

• Exclusion Indexes: These indexes work on the principle of exclusion, eliminating from their consideration companies involved in activities that don’t comply with certain ethical and sustainable criteria. For example, it could exclude companies dedicated to the manufacture of arms, tobacco or that carry out practices involving the exploitation of labour. This focus allows investors to avoid sectors and practices that are considered morally objectionable or unsustainable.  
• ESG Score Based Indexes: In contrast to exclusion, these indexes qualify companies based on their performance with regards to ESG aspects. Companies are evaluated and classified according to the effectiveness of their environmental sustainable practices, social responsibility and corporate governance. Investors can use these indexes to choose companies that not only avoid negative practices, but are also actively demonstrating a positive commitment to sustainability.
• Impact Indexes: These indexes go beyond the simple measurement of ESG performance centralising on the tangible impact that companies have on specific sustainable aspects. These indexes evaluate how investments contribute to concrete sustainable objectives, such as the Sustainable Development Objectives of the United Nations. They are particularly valuable for investors that look to generate positive change through their investments.

Evaluation Methodology: How is an ESG Rating Calculated?

The methodology to calculate an ESG Rating varies amongst qualification agencies, but there are common focus points.

Generally speaking, they collate and analyse data on a company’s practices with regards to environmental, social and governance arenas. These data points could include sustainability reports, financial records, stakeholder surveys, amongst others.

The agencies then use a set of indicators to evaluate a company’s performance on each of the three ESG segments. Each indicator is analysed given its relative importance, and a specific methodology is applied to obtain a general score.

It’s crucial to recognise that each agency has their own formula and criteria to evaluate these factors. Furthermore, inherent subjectivity in the evaluation of some ESG criteria can cause significant variations in scores between different agencies.  

This diversity in methodology underlines the importance of a wide and critical understanding amongst investors. To understand differences in how these scores are calculated it’s essential to correctly interpret its significance and to make informed investment decisions. 

Principle ESG Rating Agencies and their Methodologies

The evaluation and allocation of ESG Ratings is a complex process carried out by various special rating agencies. Every one of these agencies uses their own methodology to evaluate the performance of companies.

Amongst the most highlighted in this field include MSCI and Sustainalytics, but there are other agencies that play an important role in the ESG Ratings ecosystem.

MSCI and Sustainalytics: ESG Rating Leaders

MSCI is one of the most influential and well known ESG rating agencies on a global scale. The company evaluates more than 8,500 companies in all corners of the globe, using a focus that incorporates both artificial intelligence as well as human analysis. 

MSCI, highlighted by their Materiality Map focus, recognises that certain ESG criteria are more relevant to some industries than others. 

For example, questions regarding water usage and management of toxic waste are critical for a mining company, but aren’t as important for a technology company.

MSCI recalibrates annually their ESG qualification model to reflect changes in regulation and market expectations. 

Property of Morningstar, Sustainalytics is the other leading agency in ESG evaluation. This company assigns ESG risk based scores to companies, using a methodology that is based on 20 material questions regarding ESG, supported by 250 indicators. 

Sustainalytics uses both artificial intelligence as well as a team of human analysts to validate and analyse data, ensuring that qualifications are precise and trustworthy. 

A high ESG risk score from Sustainalytics indicates greater risk, contrary to the interpretation of high scoring amongst other qualification systems. 

Other relevant ESG Rating Agencies

Beyond MSCI and Sustainalytics, there are various other agencies playing an important role in ESG qualification:

• ISS (Institutional Shareholder Services): ISS offers a spread of ESG qualification services, centred on corporate governance and environmental and social factors that can affect the financial performance of a company.
• RepRisk: Is a data and analysis agency that specialises in the identification and evaluation of risks related to ESG and reputation. RepRisk combines artificial intelligence with human analysis to offer a profound perspective on how companies manage ESG risks.
• Bloomberg: Through their platform Bloomberg Terminal, they offer detailed information with regards to the ESG performance of companies and funds. Bloomberg gathers data from a variety of sources, including business reports and market data, to provide detailed ESG analysis and ratings. 

These agencies, alongside MSCI and Sustainalytics, form an essential part of the ESG Ratings landscape, providing to investors and companies critical tools to understand and improve sustainable performance. 

Challenges and Limitations of ESG Ratings

Despite their increasing popularity and their indisputable importance, the ESG Ratings system isn’t exempt from challenges and limitations. These challenges can influence the way in which these ratings are interpreted and used in both the investment and corporate management worlds. 

Standardisation and Inconsistent Data Problems

One of the primary difficulties in the field of ESG Ratings is the lack of standardisation among evaluation methodologies. Different agencies use different criteria and analyses for environmental, social and governance aspects, which can lead to significantly different results for the same company. 

For example, a company could receive a high ESG qualification from one agency, whilst another agency could give them a low qualification based on different parametrics and analysis. 

This lack of uniformity can be confusing for the investors and companies, as it complicates the direct comparison between ESG qualifications. 

Furthermore, the quality and availability of data used by agencies in the qualification process can vary considerably. On multiple occasions, companies aren’t obliged to reveal certain ESG information, which leads to agencies’ qualifications based on incomplete or non verifiable data. This situation can result in a biassed or incomplete evaluation of the true performance of a company with regards to sustainability.

The Impact of ESG Ratings on Investment Decisions

ESG ratings have a significant influence on investment decisions. Investors, more and more sustainably conscious, are usually drawn towards companies with high ESG ratings, under the premise that these companies are less risky and have better long term prospects. However, this focus also has its complications. 

Firstly, the perception that a high ESG Rating automatically equals a secure and profitable investment isn’t necessarily certain. Although it’s probable that companies with good ESG ratings have better performance in certain areas, it doesn’t necessarily guarantee superior financial yield.

Secondly, the impact of ESG ratings on investment decisions can lead to the over pricing of certain stocks and a potential bubble in the sustainable investment market. This can result in inflated valuations that don’t adequately reflect the financial fundamentals of a company. 

A critical viewpoint and a balanced focus are both essential when it comes to interpreting these ratings and making informed and responsible investment decisions.

Conclusion

Throughout this analysis on ESG Ratings, we have discovered its complexity, importance and inherent challenges with regards to its standardisation and application. In this context, effective management of ESG data emerges as a fundamental element. 

Our ESG management software, SUSTAINABILITY, sits at the centre of this revolution. Offering an integral solution that connects the supply chain with the ESG objectives of your company, SUSTAINABILITY permits the organisation, measurement, analysis and reporting of your ESG data in a personalised and efficient manner. Let’s Talk?

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