The Ultimate Beginners Guide to ESG Scores and Ratings

Environmental, social, and governance or ESG refer to a collection of corporate performance evaluation criteria that assess the robustness of a company’s governance mechanisms and its ability to effectively manage its environmental and social impacts. – Gartner

ESG includes standards that help measure a company’s operations around a set of criteria associated with the environmental, social, and governance aspects. Environmental criteria include factors such as natural resource usage, pollution, waste management, energy usage, and emission management. The social criteria cover factors such as the company’s relationships with its employees and customers, its CSR activities, and the work environment. Governance criteria involve factors related to internal control, executive compensation, shareholder transparency, financial and accounting transparency, and board membership diversity.

Credit rating agencies and research organizations such as Thomson Reuters, Bloomberg, Morningstar, and MSCI conduct research to evaluate companies on ESG performance and determine ESG scores. Rating agencies and research firms vary in nearly every approach to calculating ESG scoring, from the formulas they use for planning ESG ratings to how they announce their results.

ESG scores are a representation of the level of compliance of a company with the ESG parameters discussed above. There is no single accepted score and thus, there is no single accepted set of data points that determines the score. Each rating agency comes up with its own set of criteria to calculate the ESG rating, for instance, Thomson Reuters has a set of over 400 parameters, grouped into 10 themes which are then consolidated to calculate the ESG rating. The data needed to calculate the ESG score by these agencies and firms is obtained from various publicly available data sources that include annual report filings, company websites, stock exchange disclosures, and government data.

What Is Deemed a Favorable ESG Score?

  • Better brand: A good ESG score means the company is Environmentally and Socially responsible and has good Governance practices. Such companies have a better brand image among their peers and are considered ethically superior. Responsible investors tend to invest in companies that are responsible and ethical, which is why they are attracted to companies with good ESG scores.
  • Better financial performance: Organizations with a good ESG score are presumed to be better equipped to anticipate future risks and get credit easily at a lower cost than their peers, resulting in better and sustainable financial performance.

Let’s take a look at a few instances where institutions use ESG scores and learn why ESG ratings matter:

  • Retail/institutional investors: Most Institutional investors recently have started considering ESG scores into their investment strategies. Mutual fund corporations have begun ESG Funds that consist of companies with high ESG Scores. The popularity and knowledge of ESG among retail investors has picked up in the last couple of years as retail investors have started incorporating ESG scores into their investment framework.
  • Government agencies: Government agencies have the challenging task to gauge the company’s reputation and ensure that it would not exploit the environment and natural resources of its land. The government agencies tend to use the ESG ratings to assess whether the company is ethical and responsible towards the environment before granting businesses permission for land, water, electricity, and a variety of crucial resources.
  • Insurance companies: Insurance companies, especially those involved in investing in heavy machinery or corporate buildings can use the ESG scores of the companies they are insuring. This serves as an assurance to financial institutions that the companies they are doing business with would not indulge in malpractices and are environmentally and socially responsible.

Let’s explore some of the common pitfalls of ESG risk scores and how Quantiphi has been at the forefront of helping businesses around the world make smarter strategic financial decisions by tapping into the power of Natural Language Processing (NLP) and Sentiment Analysis. ESG Scores that are calculated by the rating agencies are reviewed, updated, and refreshed over intervals that can range from anywhere between 15 days to a year. Detailed review for each company happens every year, however, a few parameters are reviewed and refreshed every 15 days. As a result, if there is an event that impacts a company’s ESG score, like a fraud or a news article impairing the CEO of a company, then there will be a delay in the same being reflected in the ESG score.

ESG scores also can also be considered publicly available structured data that has been procured with the consent of the company being scored. However, there are many other insights that can be inferred from unstructured and implied data points like social media sentiment scores, weather feed, and news articles. Such information is not captured in the current ESG scoring mechanism. Some rating agencies do include unstructured data, but they lack the NLP led processing expertise required to extract the information hidden within the social media articles.

Quantiphi’s ESG Data Platform ingests streaming data in real-time and combines the prowess of NLP and Sentiment Analysis to present companies with additional insights to use alongside ESG scores to make more informed and profitable investment decisions. Interested in exploring how Quantiphi can help your business harness the power of sentiment data and NLP for making faster, better investment decisions? Reach out to our experts now.

Written byKushal Dalal
Senior Engagement Manager - Advisory Services, Banking, Financial Services, and Insurance, Quantiphi Inc.

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