Sustainable investing, also known as environmental, social, and governance (ESG) investing, has become a hot topic in the investment world. Ratings agencies create ESG indices that enable investors to evaluate a company’s ESG performance. But what are these indices and how are they determined?
Typical ESG evaluation areas
Environmental impacts are often top of mind for the ESG investment community. Investors are particularly concerned about climate change impacts linked to a company and how the company itself is prepared to cope with the ongoing climate crisis. Other areas of scrutiny include raw material sourcing, energy consumption, water, waste, and land use.
Diversity, equity and inclusion (DEI) is an important social topic for businesses in the ESG space, as is employee wellbeing. Companies that ensure fair and equitable hiring, promotion, and treatment of workers and put employee engagement and feedback at the heart of management operations fare well in these areas.
Corporate governance, organisational behaviour, ethics, and transparency are also important considerations for ESG investors. What are the policies and standards for auditing and business ethics? Are the CEO and chairperson independent? How many non-executive directors are there? Is there a sustainability department in place answerable to a sustainability leadership board? The answers to question like these are meaningful indicators of governance practice.
How ESG performance is rated
Though there may be common considerations ESG investors have in mind when deciding where to put their money, in reality there is no single, standardised checklist for a company’s ESG performance. Ratings firms or agencies create their own metrics for evaluation. They then review criteria against published company information such as annual reports, sustainability reports, board structure, news, and other information in the public domain to determine ESG scores. Some of the most well-known ratings agencies are MSCI, S&P Dow Jones, and Sustainalytics.
MSCI ESG ratings quantify a company’s handling of financially relevant ESG risks and opportunities and are intended to support investors seeking to align with their own objectives. Hence they produce a range of indices under three pillars: integration, value & screens, and impact.
MSCI applies a rules-based methodology to rate industry leaders (AA, AAA), average performers (BB, BBB, A), and laggards (CCC, B) according to how exposed they are to ESG risks and how effectively they manage those risks compared to peers.
From S&P Dow Jones come two well-recognised families of benchmark indices for the stock market investor community: S&P ESG and the Dow Jones Sustainability Index (DJSI). The S&P ESG indices are market capitalisation-weighted (meaning essentially that larger companies have more influence on the index) and track the performance of a selection of securities meeting sustainability standards. DJSI targets the top 10 per cent of ESG performers and was created for investors who want to follow stock markets while using a ‘best-in-class’ sustainability selection method.
Sustainalytics provides ESG research, ratings, and data to corporates and investors and is backed by Morningstar, an American research investment firm. Their ESG risk ratings evaluate and seek to improve a company’s current ESG performance alongside factors that can affect an organisation’s long-term performance. Their ratings vary from the best (negligible risk) to the worst (severe risk).
Why is important for companies to perform well in ESG indices?
ESG ratings can shed light on aspects of company performance beyond short-term profitability and provide a potent incentive to act on sustainability and drive changes within organisations. Companies that do well on ESG indices are seen to be more capable of identifying potential risks and opportunities in the future, more inclined to think strategically about the future, and more focused on long-term wealth development. The consequences of a poor rating can be severe when investors choose to align their ESG values with their investment strategies.
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