ESG Risk Scoring
As the balance of purchasing power shifts to newer generations, environmental, social, and governance (“ESG”) issues are now at the fore-front of investment decision making. While there are no clear mandate for companies to disclose their sustainability reporting, many companies have embraced this new investment phase by touting their carbon emission goals, their diverse talent, and superior business practices.
As ESG investment increased in popularity, it became evident we needed a way to quickly assess and compare companies based on their environmental, social, and governing impact. Independent third-party agencies and research firms have taken on the lofty goal of doing the hard work for us. They’ve created various methodologies to evaluate companies around the world and across all sectors, to determine an ESG score. Investors and advisers now have access to this important metric to make better informed decisions.
In this post, we’ll describe how independent companies calculate these scores and help provide some context to investors before making a decision. Although the reports and ratings issued are an important comparison tool when considering an investment opportunity, we’ll also talk about the limitations with the current ESG risk assessments.
What is an ESG score and why is it important?
Simply said — a company’s ESG score gauges a company’s performance on a wide spectrum of environmental, social, and governing issues. These scores help complete the picture of a company’s performance, and can inform investors on various non-financial risks.
But what does that really mean?
With the rise of social media and the quick dispersion of news around the world, many companies that negatively impact the environment or operate unethically are receiving significant criticism. That criticism often reflects in negative stock price and can present a significant investment risk to investors.
Many studies, including one by Societe Generale (a French investment banking company), demonstrated that as a result of a high ESG controversy event, two thirds of impacted companies underperformed the broader market by an average of 12% over the following 2 years (compared to the MSCI World Index). The analysis was based on 80 controversies dating back to 2005 and across various regions and sectors. A few of these examples include:
Wells Fargo engaged in fraud by opening millions of fee paying accounts without consent from its customers. The scandal broke widely in September 2016 when the Consumer Financial Protection Bureau announced $100 million of fines. Since January 2016, Wells Fargo’s stock price has returned -12.19% (vs. +55.1% for Citigroup).
Boeing’s culture of concealment and failure in design and development, combined with the federal regulator’s lack of oversight and improper certification, caused two Boeing 737 Max planes to crash in Indonesia (2018) and Ethiopia (2019). This tragedy started back in the early 2010s, where Boeing, a major US employer, faced a major financial threat. Coupled with short-term politics and greed, the integrity of the regulatory system was compromised. Since January 2018, Boeing’s stock price has returned -16.48% (vs. +28.51% for Airbus).
Facebook’s scandal hit headlines in March 2018 — Facebook exposed data on up to 87 million Facebook users to a researcher who worked at Cambridge Analytica, who also worked for the Trump campaign. The stock fell 14% on the news. Although it recovered back to highs shortly thereafter, it tumbled again when investors learned how much it would cost to monitor the website and improve security.
Volkswagen’s “diesel dupe” 2015 scandal found that many cars sold in America had a device/software in diesel engines that could detect when they were being tested and change the performance accordingly to improve results. The stock return in 2015 was -30.28%.
On the flip side, studies have shown that companies with superior ESG scores tend to have better operational performance, which ultimately translates into higher cashflows, and positive investment performance. Those companies that adhere to positive ESG principles have lower costs of capital, higher valuations, and are less vulnerable to systemic risks. Furthermore, because of the investor demand for sustainable funds, fund managers are changing their behaviors to cater to that demand.
As such, companies are now at an intersection between (1) taking actions to become more sustainable and potentially sacrificing short-term profits, or (2) be at a competitive disadvantage due to their higher costs of capital.
How are ESG scores calculated?
There are several third-party agencies and research firms that evaluate companies on their ESG performance. The most common ones are Sustainalytics, Thomson Reuters, Morningstar, MSCI, and RepRisk. The methodology, scope, and coverage vary significantly among each agency. For simplicity sake, we’ll go over Sustainalytics’ methodology. Their risk rating is based on 3 building blocks …
Corporate Governance - This is the foundational element in the risk rating, with the idea that if a company has poor governance, compliance, and oversight, the company has or will have material risks.
Material ESG Issues - This is the core of the rating, which evaluates a set of topics that require management initiatives or a similar type of oversight. The Human Capital component includes employee recruitment, development, diversity, engagement, and labor relations. The Occupational Health and Safety component ensures the health and safety of employees at their workplace. The rating is forward looking and identifies issues based on the typical business model and business environment a company is operating in.
Idiosyncratic Issues - There are issues that may become significant or material in an unpredictable manner. For example, accounting scandals is nothing predictable in certain industries more than others. These are event-driven and become material ESG issues if the event passes a significance threshold.
As you can see, there’s some element of objectivity in the calculation & weighting of the factors mentioned above. However, the idea is the same — an organization with a superior ESG score tend to be better equipped to anticipate future risks, take advantage of opportunities, adopt longer-term strategic plans, and prioritize long-term value creation over short-term gains.
Limitations of ESG scores
While measuring the corporate governance metric across industries (voting rights, board independence, number of women in management, diversity, etc.) is fairly straight-forward, the analysis of the environmental and societal impacts are much more complex.
The problem mainly comes from a lack in global standards for sustainability reporting. Although much work is underway to find a common language for organizations (large or small, private or public), we’re still a long way from being able to report on sustainability impacts in a consistent and credible way.
This results in agencies adopting different rules when aggregating common data and measuring the same categories based on different factors. For example …
Tesla has a 31.3 ESG Risk rating with Sustainalytics, which is considered high risk because of weak governance, poor labor conditions, business ethics, and product governance.
Tesla has an “A” ESG Risk rating with MSCI, which is on the high end of average within the automobile industry. MSCI rewards Tesla for their corporate governance, corporate behavior, and opportunities in clean tech.
As you can see, ESG scores for a firm can vary widely across agencies and research firms.
Lastly, sustainability and ESG ratings don’t always mean the same thing — a company could be in a sustainable industry (clean tech, electric vehicles), but be a bad corporate citizen (poor governance & labor conditions).
Closing Thoughts
Analyzing the ESG score of a company is an important metric when determining the future success of a company. Companies that focus on improving their environmental and societal impact will likely better manage risk and outperform their peers. Although there are considerable limitations to looking at a single sustainable risk score from a single agency, world leaders are actively working through making sustainable reporting mandatory, consistent, and credible. This will only help investors make better informed decisions in the future.
