Can ESG ratings meet the growing demand for high-quality sustainability disclosures?
Dealing with recent regulatory developments around environmental, social and governance (ESG) disclosures will take up considerable resources in affected organisations.
In addition, participation in ESG ratings which evaluate and quantify the sustainability performance and risks of an organisation puts further strain on the responsible departments. Will it pay off?
Notably the Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy Regulation's definitions of sustainable activities for the financial market put pressure on ESG professionals to collect and interpret relevant data.
ESG ratings in turn can play an important role in catering for the need of credible and measurable performance assessments. They provide relevant information for a variety of stakeholders such as customers, buyers or specialised investors who, for example, are interested in a company's environmental impact, its approach to board diversity, human rights and supply chain risk or biodiversity.
One common objective is to enable all stakeholders to compare performances and identify partners. Most importantly, they identify partners who are not only compliant, but also willing to meet more stringent requirements. As the regulatory frameworks becomes more stringent, will partners be able to meet their respective levels of quality, or will they fall short of expectations to provide meaningful ESG information?
Why are ESG ratings important for businesses?
Simply stated, ESG ratings help to define maturity levels for sustainability performance, i.e. commonly covering environmental data, social aspects, human rights compliance and business ethics topics and help to distinguish between laggards and leaders. The assessment results are primarily used to identify the companies e.g. with the most ambitious targets, the most advanced climate risk management or the most transparent reporting on supply chain due diligence.
Key stakeholders and investors are not only interested in the status quo of the ESG performance, but they need to understand the future value of an organization to make strategic decisions. The extent to which companies can track and report progress against their targets over multiple years is likely to become one of the most critical indicators for investment decisions. Today, material ESG topics represent the non-financial areas of business activity and performance that investors and the wider public are increasingly interested in.
The benefit of ESG scores
Many rated companies experience that their rating results improve after multiple assessments, as they start to actively engage with the respective assessment processes, if applicable. When facing the requirements defined by the ESG rating methodology, they are often supported by internal and external sustainability experts. Nonetheless, questions remain regarding how rated companies can positively influence their results, i.e. their ESG scores, through public reporting or other evidence of managing material issues. They are also seeking clarity on how to avoid negative impacts from media and controversy screenings using the ESG scores they achieved.
How do ESG ratings work?
To measure sustainability performance, the company's industry, size, location, disclosure practices, risk exposure and management, and public media screenings are usually considered. In short, most ESG ratings assess the impact of environmental (E), social (S), and governance (G) factors on an organization and how these address their impacts on stakeholders, society and the environment. Companies achieving high scores by disclosing their ESG metrics and providing evidence of mature systems and processes are believed to better manage future risks and opportunities and those with a poor rating are expected to have higher ESG risk exposure. While some ESG rating agencies assess entire management systems and operational strategies, others may focus on public disclosure only.
The methodological approach to ESG data
Typically, an ESG rating not only features different disclosure or risk categories but also a range of different methodologies. The latter is oftentimes the biggest barrier to getting started for most companies. Methodological approaches range from answering industry-specific questionnaires, submitting evidence documents, analyzing public corporate statements and reports, collecting ESG data, conducting external controversy screenings, all the way to workshops, calls by analysts and stakeholder interviews.
The duration and scope of an ESG rating
Some ESG assessment systems rely on 1-2 of the mentioned methodologies, others have a more holistic approach and combine several approaches in their methodology. This way, they aim to provide a robust picture of the company's ESG risk management and performance. Rating processes usually require several weeks to be completed, depending on the depth of analysis, the scope and accuracy of ESG data sources, and the involvement of expert analysts and sustainability consultants.
Which are the most important ESG rating agencies today?
So far, there is no obligation to perform an ESG rating assessment, unless it is required to be included in a specific index for a sustainable or socially responsible investment addressing ESG risks or because the rating is part of a business contract. Hence, companies may choose for themselves among the rating systems that best reflect their priorities and the needs of internal and external stakeholders.
These circumstances explain the variety of the ESG rating agencies landscape. However, some of them are successfully established and widely recognized at an international level, including:
- ISS ESG
- S&P Global Corporate Sustainability Assessment (CSA)
- FTSE Russel
- V.E., Moody's ESG Solutions
The EcoVadis rating covers four themes - environment, labor and human rights, ethics and sustainable procurement in the supply chain. It performs an evidence-based assessment of a company's entire sustainability management system. Initially targeting procurement organizations, it now extends its interest to sustainable finance products. As of 2022, >100,000 companies have been assessed.
Offers questionnaire-based ratings covering climate change, forests, and water security for companies, cities, and governments. The focus on reports on carbon emissions and climate change data is intended to provide a basis for investment decisions. There are 18,700 reporting companies worldwide as of 2022.
MSCI ESG ratings are particularly required by financial and investment companies and aim to measure the management of financially relevant ESG risks and opportunities. It is well established in the financial sector.
The Sustainalytics rating focuses on ESG risks and their management. It assesses the management gap for all ESG issues and takes unmanageable risks into account. The rating does not involve any input or engagement by the assessed entity. It is targeting companies and investors to address ESG issues that pose a financially material risk.
The Institutional Shareholder Services (ISS) ESG ratings analyse 100 sector-specific rating criteria. These include topics such as climate change, UN SDGs, biodiversity, human rights, labor standards, corruption, controversial weapons and many more. It is particularly requested by investors and companies looking for ESG and governance risk mitigation as a shareholder value.
The CSA rating analyzes engaged questionnaire ESG data and publicly available data. The top performing companies are included in the DJSI World Index. 8,000 of the rated companies represent 90% of the global market capitalization.
FTSE Russel ESG ratings consist of an overall rating broken down into underlying pillar and theme exposures as well as scores applied to each company's unique circumstances. It enables investors to comprehend a company's exposure to and management of ESG aspects on a quantitative level.
V.E. (Vigeo Eiris) was acquired by Moody's in 2019 to strengthen its ESG Solutions and provides ESG research and services for investors and public & private organisations. V.E. bases its ratings on 23 areas including climate change, health, safety, and environmental issues to human and labour rights. Assessments are conducted every two years. 5000+ ESG assessments of large cap-companies were performed as of 2022.
Will ESG rating agencies be regulated or standardised in the future?
The offer of ESG ratings has evolved in the recent years and their use is expected to further increase. A recent public consultation carried out by the European Commission among private sector participants, including financial services and other professional associations, revealed an extensive use of ESG ratings that provide insights into the impact of companies on society and environment.
Nevertheless, the rating landscape is often criticised for being a maze, lacking transparency as to the underlying methodology or objectives, or being biased. According to the EU report, the large majority (81%) therefore uses a combination of ESG ratings covering multiple topics and more granular solutions focusing on different areas such as climate change. Overall, the market for ESG ratings does not seem to be functioning well (yet).
Rating agencies are currently not subject to regulatory oversight addressing the need for more transparency and standardisation. This is critical as according to the EU report, “almost all respondents (94%) consider that intervention is necessary” and the majority (82 %) considers that “ESG rating providers should be subject to some form of authorisation/registration regime in order to offer their services in the EU” (European Commission, 2022) 1 .
ESG ratings are influenced by the regulatory dynamics of the European Union
Most ratings are steadily adjusting to the market requirements as well as the regulatory dynamics. Laws with relevance to ESG which are already in place or about to come into force already provide clear direction for providers and users of ESG ratings. These include:
Corporate Sustainability Reporting Directive (CSRD) – Reporting framework significantly expanding existing rules on the scope and method of sustainability reporting, affecting an estimated 50,000 companies in the EU.
EU Taxonomy Regulation - Establishes verifiable criteria by which economic activities of companies can be categorized as "environmentally sustainable."
Task Force on Climate-Related Financial Disclosure (TCFD) – Reporting on governance, strategy, risk management and metrics related to climate risks, mandatory in some states, e.g. the UK and New Zealand.
Sustainable Financial Disclosures Regulation (SFDR) - Affects asset managers and fund providers and requires assigning their financial products to one of three sustainability categories under Article 6, 8 or 9.
If applied in the right context, they are a useful vehicle to engage with suppliers, investee companies or partners, to structure and standardise collection of relevant information and to pass on legal requirements to those concerned. An increase in transparency may eventually enhance business relationships in the long term.
How AFRY can support companies demonstrate leadership in ESG performance
AFRY has long-established experience in assessing environmental and social compliance at company level. Our experts provide insights into the variety of rating systems, their quality claims, purpose, underlying methodology and target groups.
The ESG rating landscape appears to be complex and companies are often lacking a full understanding of how scoring systems work. AFRY understands the challenge that companies are facing and provides guidance on how to improve rating results, focusing on improvement areas with the highest leverage. AFRY can help answer clients’ questions in the wider context of their ESG strategy:
What is your status quo ESG performance and level of maturity?
Who are your main stakeholders and target groups for your ESG rating?
Which sustainability topics represent the most material concerns for your company’s profile?
Which ratings are relevant to your industry, size and external communication?
How can your company best present its ESG risk management system(s) in a credible, transparent and comprehensible way?
AFRY has been successfully supporting companies from a variety of sectors
AFRY helps during the preparation for an ESG rating and develops a customised approach to achieve the desired goal, e.g. a specific scoring level. Our goal is to improve our clients' ESG rating results for long term value creation.
In 2022 we worked with one of our clients, a large German automotive supplier, for the second time in raising their EcoVadis rating score and showcasing their strong ESG commitment. We developed a detailed corrective action plan based on their existing scorecard with concrete improvement measures, we supported during the choice of evidence documents and we reviewed the questionnaire responses before submission.
We organised workshops for a Swedish healthcare group addressing the lack of transparency concerning the EcoVadis rating methodology. With our support, the company has improved their score significantly and reached Gold status in 2022. AFRY’s team of experts further helps review relevant management system documents such as company policies and guidelines to foster improvements beyond rating results.
Whether you are at the beginning of your ESG journey or if you are more experienced with rating systems, AFRY’s team can help you to efficiently improve your mode of operation and results. Contact our ESG rating lead Pia Dewitz.