For those who aren’t familiar with the term, ESG stands for Environmental, Social, and Governance, three basic criteria on which public companies are now rated, ranked, and compared. The concept is kind of like posting calories on a menu: Theoretically, by informing the public how well a company is performing on these issues, investors have a better understanding of the potential risks they face and a company’s likelihood to grow in a sustainable way.
ESG ratings quickly gained popularity with investors as a way to assess a company’s vulnerability to lawsuits, and environmental and other crises. Today, managers of one-third of all professionally run assets globally use ESG data to inform their investment decisions.
Not all are convinced of the value of ESG ratings, or even of the corporate social responsibility they measure. Witness a recent warning by the US Labor Department that ESG may not be an appropriate measure of a company’s worth. The market seems to disagree. When compared to others in their category, companies with the highest ESG scores appear to consistently outperform their competitors in the stock market.
As a result, an organization’s ESG score has gained a spot on many corporate dashboards. It’s now found alongside other key business performance indicators, like rank on Fortune’s Most Admired list, or Best Place to Work, or employee engagement. And of course, responsibility for ESG score reporting—a tedious process of tracking down a large number of disparate data points—frequently falls to corporate communicators. So we thought we’d provide a bit of background…
The first ESG rating was the Dow Jones Sustainability Index (DJSI), created in 1999 based on data from RobecoSAM. Today there are more than 600 different organizations providing ESG ratings. Most ratings are subscription-based information services. Sustainalytics’ index, however is offered for free on Yahoo Finance. Here is an example:
How Are ESG Ratings Derived?
Some ESG rating organizations, like Thomson Reuters, base their information on publicly available data: annual reports, news coverage, etc. Others use self-reporting questionnaires that can create months of work inside companies: filling out surveys, verifying information, fielding calls with investors and ratings agencies, etc. Some only rate companies that participate, others rate any companies on which they can gather data.
For the DSJI, an annual industry-specific questionnaire is sent to participants asking for data. The questionnaire includes 80-120 questions covering topics such as corporate governance, risk and crisis management, codes of business conduct, customer relationship management, policy influence, brand management, tax strategy, information security, cybersecurity, privacy protection, environmental reporting, environmental policy and management systems, and operational eco-efficiency.
Rating firms also use externally available data to track whether a company has been involved in incidents or events that may negatively impact stakeholders, the environment, or the company’s operations. Controversies are typically rated on a scale from one to five, with five denoting the most serious controversies with the largest potential impact.
How Best to Use ESG Ratings?
Different ratings are not comparable. Some, like DJSI use only 100 criteria, others consider as many as 400 different data points. To make matters more complicated, each index uses different criteria, methodology, and rating scales. So your best bet is to pick one rating and measure progress over time.
Another challenge is that the companies included within any given index vary considerably. For example, the DJSI only includes the top 10% of the largest 2500 companies across 60 industries. So before you settle on one rating, make sure all your key competitors (or whoever you’re benchmarking against) are also in their rankings.
4 Tips for Adding ESG to Your Dashboard
Our advice is that, if you are going to add an ESG score to your dashboard or list of KPIs, then find one that:
- Is used and accepted by your investors,
- Includes the most number of companies in your industry or marketplace,
- Uses criteria that are appropriate for your industry, and
- Doesn’t require an unreasonable amount of work or cost to participate in.
Further Reading on ESG
Want to do a little ESG research on your own? Start here:
- SustainAbility’s Rate the Raters paper, and
- Sustainable Perspective For the Mainstream Investor, from Sustainable Insight Capital Management.
All the best, and let me know if you have concerns or problems. ∞