ESG Ratings: Who Assigns Them? How Do They Originate? And Why Are They Important?

ESG Ratings: Who Assigns Them? How Do They Originate? And Why Are They Important?

Dec 12, 2024 5 minutes

ESG ratings are scores that shed light on how sustainably companies operate. Learn in this blog post how ESG ratings originate and what purpose they serve.

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Why do people invest their money? Quite simply, to multiply it. That intention lies behind almost every investment, but it is increasingly being attached to conditions. Although profits are still the driving motive for investors and will always remain a primary objective, these days investors are taking an ever closer look at how the money is earned. Maximize profits? Yes, but not if it comes at the expense of the environment or exploited workers. ESG ratings are instrumental to forming a picture about which companies boast a sound ESG profile and what potential ESG risks an enterprise could have. In addition, ESG ratings make a company’s progress in the area of sustainability measurable and comparable. In this blog post, we take a closer look at ESG ratings. Who produces them? How are they calculated? And why is it crucial for companies to achieve a good score?

What Is ESG?

In order to understand what ESG ratings are, one must first grasp what ESG means. We already explained the meaning of ESG once before in an extensive article in this blog. For those who don’t have time or a desire to read the whole article, here’s a brief summary of it:

ESG stands for environmental, social, and governance, and denotes a set of criteria used to evaluate the sustainability and ethicality of a company’s business practices.

The term “environmental” refers to all aspects of a company’s use of natural resources. The term “social” encapsulates a company’s relations with its stakeholders, i.e. with its employees, customers, suppliers, and society in general. The term “governance” deals with the way in which a company is run and managed.

What Is an ESG Rating?

To recapitulate: environmental, social, and governance are criteria used to evaluate companies. An ESG rating defines and quantifies these aspects, measuring the performance or risk of a company across all three of those domains or parts of them. ESG ratings usually employ a scoring scale ranging from CCC to AAA or from 0 to 100, for example. The scores help investors form a picture of a company. But investors aren’t the only ones who pay attention to ESG ratings. Nowadays, ESG ratings also carry great weight in the business-to-business (B2B) context. There are special ESG ratings specifically designed to enable companies to gauge the sustainability of their suppliers and business partners.

How Does an ESG Rating Originate?

First of all, the process of generating an ESG rating is not standardized, and there is more than one agency that produces ESG ratings. A number of ESG rating providers compete with each other, and each one uses its own methodology. MSCI, Sustainalytics, S&P Global, and – in Switzerland – Inrate and RepRisk rank among the best-known ESG rating agencies. In the B2B context, Ecovadis, for example, is a key player. If it is only about the “E” in ESG, CDP is an important rating agency, focusing primarily on climate, water, forests, and plastics.

The different approaches employed by the various agencies sometimes make it hard to compare ESG ratings. But regulatory pressure is mounting, and the agencies are constantly working on making their ratings transparent and standardizing them to render them comparable with each other.

Although all rating agencies’ methodologies differ from each other in their details, the work steps they follow normally are similar. The specific ones listed below are critical:

  1. Evaluation of Rating Criteria
    An agency must first define what factors are essential to calculating an ESG rating, asking the following questions: Which ESG factors might affect a company’s success? And which ESG factors harbor potential legal, reputational, and regulatory risks? Those factors may vary depending on the size of a given company and the sector and locations in which it operates.

  2. Data Collection
    Once the criteria have been defined, a rating agency then needs to gather corresponding data. There are generally two ways to collect the data. A rating agency either gleans the data from information in the public domain, such as from companies’ annual reports and sustainability disclosures and from media reports, or the companies to be assessed fill out ESG questionnaires and submit them to the rating agency.

  3. Scoring System
    Once all of the necessary data have been collected, then comes the next challenge: agencies must turn the data into a rating. That requires a system for scoring and weighting each data point. Here, too, each rating agency applies its own methodology. The weighting of each aspect ultimately is very customized and again differs from industry to industry.

Interestingly, most ratings are based on a comparison with other companies within the same sector. So, a good ESG rating doesn’t necessarily mean that a company is operating its business very sustainably, just simply better than the comparator group defined by the rating agency.

Why Is a Good ESG Rating Important?

Companies benefit greatly from a good ESG rating, profiting on multiple levels. The most beneficial aspects are enumerated below:

  • Attractiveness for Investors
    A good ESG rating is an indication that a company has a sound ESG profile. Investors these days are prioritizing sustainability in their investments. A survey by Deutsche Bank found that 53% of all investors regard climate change as the most important factor affecting their investment decisions. Moreover, institutional investors are increasingly being obligated to integrate sustainable assets into their investment strategies. Furthermore, a better ESG rating improves a company’s odds of getting included in ESG indices, which are gaining increasing popularity among investors.
  • Better Conditions for Raising Capital
    A good ESG rating is synonymous with less risk, which can result in better conditions when raising capital.

  • Reputation and Customer Loyalty
    ESG factors are eminently important not just to investors, but also to consumers. Sustainability is playing an ever bigger role in people’s shopping decisions.

  • Regulatory Compliance
    ESG regulations are becoming more and more stringent. Companies with a sound ESG strategy are better equipped to face present and future regulatory requirements.

  • Attracting and Retaining Talent
    Job seekers increasingly want to work for sustainable companies. That particularly goes for the younger generations. More than half of Generation Z members (55%) and millennials (54%) research a company’s environmental impact before accepting a job, according to a study conducted by Deloitte.

  • Suppliers and Customers
    The pressure for greater sustainability is also increasingly getting passed on along the entire value chain.

Sustainable Companies Get Rewarded

ESG ratings, though, also get criticized. Different rating agencies with differing methodologies create divergences in ESG scores. The criticism is justified. ESG is a relatively young subject, and practices and regulations are constantly evolving. International bodies like the International Organization for Standardization (ISO), for example, are working on the standardization and comparability of ESG information. Nevertheless, it has already become evident that companies that do business sustainably get rewarded for that in the long run. Operating sustainably is a vital factor in the face of global challenges like climate change. This trend looks set to gain further momentum in the years ahead because sustainable business practices are increasingly being viewed as an integral part of a future-proof economic system.

Discover the ESG Indices from SIX

Companies with a good ESG rating from Inrate make it into the ESG indices from SIX, which provide sustainability benchmarks for the Swiss capital market. Learn more about the indices on offer.

 

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