Why ESG Scores for Companies Matter. A Lot.
People need receipts these days. Fair or not, to a massive swath of the marketplace, if you can't prove it, it didn't happen. Or, at the very least, people will look at you sideways, and that's not exactly great for business.
That's why ESG scores are so important – they serve as those critical receipts, the ones that demonstrate how seriously your organization takes ESG and business ethics, the effectiveness of your ESG gameplan, and how you stack up against industry peers. Because, as we're about to discuss, healthy ESG scores might just be the competitive advantage you've been looking for.
ESG and Expectations
Before we plunge headfirst into the deep end of the pool, let’s get something out of the way – you may or may not put much credence into ESG. And we’re not asking you to justify your position because, as many great minds have said, it is what it is.
But your customers and stakeholders might be asking for such justification, and that’s an entirely different ballgame. Because, whether you see it as an absolute necessity, overreaching hindrance, or you’re completely indifferent about it, ESG is here to stay, and is already an expectation across much of the marketplace.
Therefore, yes, you can maintain a laissez-faire approach to ESG by not taking the scores and rankings we’re about to delve into seriously, much less striving to improve them. But in the process, there’s a very good chance you’re sacrificing what amounts to a massive opportunity to differentiate yourself, simultaneously adding significant value to your organization.
And now back to our regularly-scheduled programming.
What Are ESG Scores?
If we’re to distill everything ESG means for an organization into a single word, it would be risk. Like the labor markets, supply chain disruptions, or a global pandemic – to keep our context hyper-relevant – ESG represents a sink-or-swim scenario for businesses, substantial possible downsides counterbalanced by massive, potentially market-making upsides.
Companies that can successfully navigate their exposure to environmental, social, and corporate governance risks are inherently more attractive to many customers, investors and shareholders, strategic partners, bankers, and other stakeholders. ESG scores provide all of these entities with a simple, convenient, and comparable gauge they can use to judge how well a company is addressing risks from areas like:
- Energy usage and sustainability
- Safety in the workplace
- Diversity and inclusion (D&I)
And that's just the tip of the iceberg. A truly comprehensive list of risks that a company’s ESG strategy – or lack thereof – must address could go on for days, and will only grow in the future as the ESG landscape continues to mature.
Further, ESG scores provide insights that aren't always obvious in standard financial reporting or analyses. Yes, the SEC's recently proposed climate risk disclosures will help provide needed transparency once formalized, but a concise ESG score will always be more convenient – at least for a high-level view – than a few minutes spent digging through EDGAR.
Ultimately, a robust ESG rating or score tells the world that an organization is handling ESG-related risks well compared to other companies. Conversely, if a business has an ESG score that isn't too rosy, then – right or wrong – people and stakeholders will interpret that as a poorer job of traversing ESG risk, at least in comparison to others.
The bottom line – your ESG score, along with traditional financial statements, expert analysis, and ESG-specific reporting and metrics, help investors and others understand how you'll address ESG-related risks, both now and down the road.
Where do ESG Scores come from?
Thankfully, ESG scoring isn't random or ill-planned. In fact, despite ESG criteria and regulations still being young and rapidly evolving, several third-party agencies already specialize in establishing ESG ratings for companies, including:
- S&P Global
- Dow Jones
But who calculates the ESG scores perhaps isn’t as important as how they calculate them, at least as leadership develops a strategy. While each individual rating agency uses financial statement filings, disclosures, and independent research in its process, they also develop their own criteria for assessing ESG performance against that criteria.
Voluntary disclosures are also especially important for third parties to rate companies, giving ESG rating agencies tangible metrics they can use to help form a company's scores. Drilling down even further, such disclosures typically use at least one of the more popular ESG disclosure frameworks as a guidepost, including:
- Global Reporting Initiative (GRI)
- Task Force on Climate-Related Financial Disclosures (TCFD)
- Sustainability Accounting Standards Board (SASB)
- International Sustainability Standards Board (ISSB)
- GHG Protocol Corporate Standard
Granted, each agency has its own methodology – proprietary razzmatazz and algorithmic wizardry – to transform ESG data points on greenhouse gas (GHG) emissions, human capital management, and other critical ESG factors into actual scores. But they also use different scoring formats, some preferring a fixed income-like scale from AAA to CCC, while others favor straightforward numerical scales. Therefore, what constitutes a "good" score won't be the same across the board.
For instance, as of this writing, Microsoft has a AAA rating from MSCI, a 58 from S&P Global, and a 15.2 from Sustainalytics, each representing an excellent score with low ESG-related risk. These scores all come from the agencies' proprietary formulas using weighted risks and probabilities on typical areas like a company's carbon emissions, human rights, sustainability and renewable energy, and governance issues, among many more.
Why ESG Scores Matter
As we said up top, like it or not, the world is looking at your organization through ESG-tinged lenses. And that dynamic will only increase with time. Thus, given how convenient ESG scores are for gauging a company's commitment to ESG and the effectiveness of its strategy, think of the scores as the ESG equivalent to Rotten Tomatoes for moviegoers.
In this analogy, those moviegoers are the investors, partners, bankers, and customers looking for companies that align with their own perspectives on ESG and, perhaps even more importantly, appear to have a sound strategy to address ESG–related risks. In the real world, that can inform investment decisions, reduce cost of capital, and drive beneficial strategic partnerships for companies with a sound ESG strategy and, thus, robust ESG scores. In other words, it’s a competitive advantage waiting to happen.
ESG investing alone has become a juggernaut over the past few years, largely shaping asset managers' investment strategies and propelling organizations like ISS ESG, not to mention a host of ESG-oriented ETFs. Now, a company's ESG performance – as measured by ESG risk rating issuers – can either distinguish it as a responsible, sustainable investment, or as an ESG laggard. And no one wants to be in that second group.
None of this is to say that a 'good ESG score' from the fine folks at MSCI ESG Research, for example, is a flawless ESG barometer, with both agencies and scores having their own set of limitations. However, they're certainly vital to a bigger picture that also includes annual reports, disclosures on material ESG issues, specific sustainability reporting, or even PR and other qualitative measures. Collectively, the importance of this targeted ESG information will only continue to grow in lockstep with ESG itself.
If all of this seems overwhelming to you, just know you're not alone as many companies are struggling to catch themselves up to speed. Still, the clock is definitely ticking, especially with the SEC now taking action. If you find yourself needing a sense of direction, our advice is to look over some of our previous insights on ESG, particularly our guide, ESG Reporting Best Practices: Implementation & Beyond. And of course, the specialists on our ESG and Sustainability team are always available to help get your reporting strategy in tip-top shape.