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What is an ESG score and how is it calculated?

What is an ESG score and how is it calculated?

With environmental, social and governance issues growing in prominence in every sector, the ability to manage ESG risks and opportunities is increasingly important to the bottom line. But to calculate its ESG liability, a company first needs to know its ESG score

What is an ESG score?

An organisation’s ESG score is, simply put, a numerical measure of how it is perceived to be performing on a wide range of environmental, social and governance (ESG) topics.

These can either be material to the company, or important to its stakeholders for non-financial but equally compelling reasons. An ESG score is a way for organisations internally, and also for the wider corporate ecosystem, to assess and understand ESG performance.

The operative word in the previous paragraph is ‘perceived’. An ESG score is calculated based on how an organisation is seen to be performing – that is, how its behaviour relating to ESG issues is reported. Just as with the building of corporate reputation, there is a gap between reality and perception. While a business may have a strong policy around carbon emissions and waste reduction, or a system of transparent, performance-based promotion, if that information is not in the public domain, it won’t impact its ESG score.

If its ESG score doesn’t reflect the internal reality, chances are the company’s ESG position is not being properly understood by its stakeholders. And as ESG scores only measure how corporate behaviours are reported, part of their value lies in revealing any gaps between the internal corporate reality and external perception. A reality gap poses a risk, making it incumbent on businesses to report comprehensively on ESG factors to ensure their ESG score is accurate.

Why do you need an ESG score?

An ESG score is a wake-up call, one which should focus board members on their ESG liability, where risks and opportunities lie, and how they are performing against the wider sector.

Do they need to rethink corporate strategy in light of ESG performance? Is their corporate reporting sufficiently detailed on ESG issues to take advantage of the growth in sustainable investing – or will they miss out because they are not promoting their ESG credentials?

There are myriad reasons besides understanding its ESG position why a business needs an ESG score. Perhaps the most significant is the rapid rise in ESG investing, with investors looking for portfolios of sustainable assets. With a reliable connection shown between strong performance on material ESG issues and financial performance, ESG scores are used by institutional and independent investors to identify companies likely to offer good returns. Asset managers are equating a good ESG rating to healthy profits.

An admirable ESG profile wins with other stakeholder groups too. Employees looking to match their own priorities with those of potential employers are looking closely at their environmental, social and governance policies. An ESG score provides an easy way for savvy job hunters to compare the relative merits of their prospects, and scoring well will help businesses to hire the best talent. Similarly, NGOs and campaign groups are less likely to negatively target companies with good ESG scores when exposing unsustainable practices.

Internally, an ESG score derived from weighting ESG liabilities across a wide range of issues, taking into account sector specific factors, will enable businesses to identify ESG opportunities and risks. If the areas where the business scores highly equate to factors that are authentic to its purpose, then they are more likely to be financially material. Reduced fuel consumption will be more impactful for an airline than a merchant bank; while allocating a percentage of profits to rescue shelters will chime well with a pet food company’s customers.

Conversely, an ESG score will be less responsive to bandwagon-based behaviours. Press releases about environmental initiatives are not a proxy for authentic ESG policies. It is nonetheless important to communicate the company’s ESG credentials, to close any gap between perception and reality. Ensuring all stakeholders understand a business’s ESG position is not just the communications team’s role. For a subject that is so all-encompassing, every employee effectively acts as an ambassador and representative of the company’s ESG ethos.

How is an ESG score calculated?

With the growing need to quantify a business’s ESG performance, different scoring systems have emerged. Analysis companies offering various calculation processes are offering to create bespoke ESG scores for clients, but, just as ESG scoring is the measurement of perception rather than reality, so ESG data systems can be largely subjective.

Opaque methodologies make it hard for organisations to understand where their score has come from, and mean that it will vary depending on which analyst they employ. Research by State Street showed only a 0.53 correlation between ESG scores for the same subjects from MSCY and Subanalytics.

A reliable scoring system needs to be objective, accurate and consistent. It should be able to provide comparable scores for businesses across sectors and geographies. It should encompass the perceptions of all stakeholders.

Where ESG scoring systems have historically fallen short is in the integration of Alternative Date. As we have set out in detail in our white paper on the measurement challenge of ESG, ESG ratings and scores are often based on voluntary company self-disclosure and partial data. To be both accurate and reflective of the speed of development of ESG issues, more comprehensive data is needed. To that end, an ESG scoring system should include real-time analysis of millions of pieces of publicly available print, online and broadcast news, and social media content. Its scope should span everything from national reporting to blogs, regulatory disclosures and NGO communications.

The process should factor in volume of coverage, share of voice, influence of the source and prominence of the issue. In order to analyse the sentiment contained in millions of pieces of content in multiple languages, ESG scoring requires machine learning and natural language processing (NLP) technology, combined with expert human oversight.

To help eliminate subjectivity, scores can be indexed against universally accepted benchmarks, such as the Sustainability Accounting Standards Board (SASB) standard taxonomy. This offers a comprehensive reporting framework of ESG issues by sector.

The SASB is also developing accounting standards for sustainability metrics, allowing companies to report on financially material ESG issues in a systematic way. By including these accounts in their annual reporting, businesses can ensure their ESG scores are more accurate, and therefore more useful for corporate governance and investment decisions.

The more reliable an ESG score, the more consistently it is calculated and referenced, the greater the impact it will have on long-term performance, by managing ESG risks and opportunities, encouraging impact investing, and driving corporate governance to create a more sustainable business.

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