Why ESG ratings matter and how companies use them

The importance of ESG ratings for investment

With huge interest and the growing importance of Environmental, Social, and Governance (ESG) criteria, investors need a way to objectively assess a company’s ESG performance. An ESG criteria is thought to help investors consider the ‘unmeasured’ or ‘unrepresented’ environmental, social and governance topics when making investment decisions. It reveals data that traditional financial analysis doesn’t usually capture, speaking to a company’s sustainability in its broadest sense. This has led to the flourishing of several ESG Rating Agencies, such as Sustainalytics, MSCI and FTSE ESG, which assess companies globally on their ESG performance and make this data available to their clients. These ESG ratings are designed to help investors identify and understand financially material ESG risks to a business. Companies are evaluated based on publicly available information such as media sources and annual reports, with scores given for each material ‘E’, ‘S’ and ‘G’ topic, alongside an overall score. Investors use these unique scores as a proxy of ESG performance. Companies that score well on ESG metrics are believed to anticipate future risks and opportunities better, be more disposed to longer-term strategic thinking, and focus on long-term value creation.

The impact of ESG ratings on investment

With investors using ESG scores in their investment strategies, ESG criteria have turned out to be incredibly valuable, with ESG portfolios continually outperforming traditional portfolios. A study by Frontiers on the impact of ESG on financial performance indicates that companies that integrate ESG principles into their strategies tend to attract a broader range of investors who prioritise sustainability and social responsibility. This can lead to increased capital flow and enhanced financial performance.¹ In a similar vein a meta-analysis of over 2000 studies confirmed that the responsible, as well as the economic case for ESG investment is tangible.² Conversely, the consequences of a poor rating can be significant. If, for instance, your company received a poor rating from one ESG data provider, your stock may be considered an ‘unsustainable asset’ by investors and be excluded from their investment portfolio. If multiple investors follow this reasoning, this can eventually negatively impact your stock price. In Europe, where most assets under management are invested in ESG funds or strategies with some sustainability-related focus, understanding your ESG scores and improving year-on-year is important for your company to continue to attract investment.³

ESG ratings as a tool for internal benchmarking and improvement

It is also essential to recognise that ESG ratings can be a valuable internal benchmarking tool to guide decision-making and improve sustainability performance. An evaluation by an external expert on your company’s ESG performance gives an independent view of performance and how it compares to competitors and peers. This can be a powerful incentive for taking action and steps towards increasing performance. Further, the assessment can provide a valid source of information to help internal advocates promote change and highlight areas of particular weakness and strength.

ESG ratings under scrutiny

Despite their value, ESG ratings have faced criticism for inconsistencies and a lack of standardisation across different providers (i.e Sustainalytics, MSCI and FTSE ESG). This variability has prompted calls for greater methodological rigour and transparency within the ESG rating industry. By standardising ESG assessment criteria, these regulations are expected to foster greater confidence in ESG ratings and support more informed investment decisions. This approach ensures that companies and investors consider how sustainability issues affect financial performance and how corporate actions impact broader societal goals.

In a significant development, on 13 June 2023, the European Commission (EC) presented a proposal to regulate ESG rating providers. The proposed rules concern the following:

Authorisation and supervision by the European Securities and Markets Authority (ESMA) of third-party providers of ESG ratings and scores
Separation of business for the prevention and management of conflicts of interests
Proportionate and principle-based organisational requirements,
minimum transparency requirements to the public on ratings methodologies and objectives and more granular information to subscribers and rated companies
Transparency of fees and requirements for fees to be fair, reasonable and non-discriminator
Possibility for third-country providers to operate on the EU market if equivalence, endorsem*nt or recognition.⁴

On 05 February 2024, the EC reached a provisional agreement on a proposal. The provisional political agreement is subject to approval by the Council and the Parliament before going through the formal adoption procedure. The regulation will start applying 18 months after its entry into force. The new rules aim to govern the reliability and comparability of ESG ratings, ensuring they provide a more accurate reflection of a company’s sustainability performance. It is rumoured that the double materiality assessment methodologies for financial impact may inform ESG rating methodologies. Introducing double materiality into ESG assessments and ratings brings a more comprehensive and nuanced understanding of a company’s sustainability performance. It will encourage companies to adopt a more holistic view of their role in society and the environment, driving them towards strategies that mitigate risks, enhance financial performance, and contribute positively to societal and environmental outcomes.⁵

Navigating ESG Ratings in the era of double materiality

In 2024, the concept of double materiality will become increasingly central to understanding the full impact of ESG factors on investment decisions and corporate performance. Double materiality extends beyond traditional financial materiality to encompass both the financial impact of sustainability issues on a company and the company’s impact on society and the environment. This dual perspective on materiality is critical in the context of ESG investment and reporting, as it acknowledges that the significance of certain ESG factors can vary.

From a financial materiality standpoint, investors are concerned with how ESG factors can affect a company’s financial condition and operational performance. For instance, a company’s carbon footprint may have direct financial implications regarding regulatory compliance costs, potential fines, and the shift in consumer preferences towards more sustainable products. Conversely, the broader lens of double materiality also considers how a company’s activities impact the environment and society. This includes the company’s contribution to climate change, engagement with local communities, and governance practices. This aspect of materiality reflects a growing recognition within the investment community that companies play a significant role in addressing global challenges such as climate change, social inequality, and corporate governance.

The future of ESG ratings

The role of ESG ratings in investment decisions and corporate sustainability strategies is undeniable. As the financial landscape continues to evolve, with a growing emphasis on sustainability and ethical practices, ESG ratings will remain a key tool for investors and companies. They facilitate informed investment decisions and drive companies towards more sustainable and responsible business practices, ultimately contributing to a more sustainable and equitable global economy. In the coming years, and with the EU setting the tone, we can anticipate further regulation of rating agencies and the standardisation of methodologies. It is also foreseeable that double materiality assessments will inform and complement ESG ratings, which will play a pivotal role in shaping investment strategies and decisions.

Why ESG ratings matter and how companies use them - Simply Sustainable (2024)