Environmental, Social, and Governance (ESG) ratings have become a major topic of discussion in the economic world, but what do they actually mean?  

Let’s go through the history of ESG and look at what the individual ratings mean for businesses.  

History of ESG 

The United Nations were the first major organization to mention ESG in their 2004 report, Who Cares Wins. The report, endorsed by the likes of Goldman Sachs, HSBC, UBS and Morgan Stanley among others, was built on the premise that in the modern world, the way companies handle ESG related issues is more important than ever for both shareholders and investors. Through strong E, S and G values, businesses can create additional value for their customers as well as build on their brand reputations for even more shareholder value. 

What is E, S and G? 

But what do E, S and G factors really mean or include?  

Here is the list of examples of ESG issues relevant to investment decisions from the UN:  

Environmental issues: 

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• Climate change and related risks 
• The need to reduce toxic releases and waste 
• New regulation expanding the boundaries of environmental liability with regard to products and services 
• Increasing pressure by civil society to improve performance, transparency and accountability, leading to reputational risks if not managed properly 
• Emerging markets for environmental services and environment-friendly products 

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Social issues: 

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• Workplace health and safety 
• Community relations 
• Human rights issues at company and suppliers’/contractors’ premises 
• Government and community relations in the context of operations in developing countries 
• Increasing pressure by civil society to improve performance, transparency and accountability, leading to reputational risks if not managed properly

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Governance issues: 

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• Board structure and accountability 
• Accounting and disclosure practices 
• Audit committee structure and independence of auditors 
• Executive compensation 
• Management of corruption and bribery issues

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While there is not currently a set criterion to measure a company’s ESG, this list summarizes many of the data points used by ratings firms to determine the ESG rating of a company. 

How is ESG used today? 

Demand for ESG information from companies and investors alike has skyrocketed over the past two decades. In response to this, firms have created ESG ratings, an alphabetical or numeric scale that, according to the EU “generally assess the impact of environmental, social, and governance factors on a company and a company’s impact on the outside world.” Ratings are given by independent firms such as MSCI or ISS ESG who are hired by the assessed company and use hundreds of data points to determine a final score.  

Many believe that a company’s ESG rating represents the impact it has on the welfare of its investors, employees and the environment. They believe that a high score indicates an ethical firm, and that an ethical firm will automatically have a high ESG rating. While some ratings firms use data points that support this interpretation, it is only a small fraction of the larger picture. In actuality, ESG ratings are indications of how societal and environmental factors could affect a company’s long-term profitability. Companies that mitigate risk caused by these factors are expected to have strong long-term financial performance and typically receive a higher rating.  

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So what does this mean? 

As stated above, ESG ratings are the product of hundreds of data points comprised together to get one final score. But what metrics do firms use and what do they say about a company? In addition to a total ESG rating, companies are also given individual ratings for E, S and G respectively. While each ratings firm uses different data points, there are many common themes in their research. 

Environmental: Environmental ratings stem from the environmental impact a company has and the potential risks that those impacts have on their financial performance. Data points that can fall under Environmental include a company’s greenhouse gas emissions, energy use and efficiency, carbon footprint reduction and impact on the biodiversity of the region the company is operating in.  

Social: This category typically encompasses the treatment of employees below the executive level and how it could affect future performance. Examples of this could include adherence to the labour laws in which the company is operating in, general workplace health and safety conditions and responsible supply chain partnerships. 

Governance: A company’s governance rating usually refers to the actions of those at the executive level. This rating could consist of points such as a company’s overall risk management, tax and earnings transparency and shareholder rights. For example, a company that is not transparent about the taxes they pay will receive a lower score because it is seen as a riskier investment than a company that is. 

For a company to improve their rating in any of these categories, a quota of some sort typically has to be met. Whether it be an increase in employee pay or a reduction in greenhouse gas emissions, change must be made within a company if they wish to improve their rating. 

Why is this relevant to you?  

As an investor, knowing how to interpret and contextualize a company’s ESG rating can help you make more informed investment decisions. Ratings can offer a more holistic view of a company and its practices, giving you more insight into where you’re putting your money.  

While a strong ESG rating can inspire confidence in a potential investment, it doesn’t paint the full picture. In this article, I discuss the nuances of and controversies surrounding ESG ratings, and how ESG investing differentiates from other strategies like ethical investing. 

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