A Guide to Understanding ESG Ratings

Investors passionate about environmental, social, or governance concerns often use the ESG ratings to assess companies or equities worth investing in. The ESG rating tells investors the level of risk exposure a company has in these three areas. Therefore, issues such as energy efficiency and sustainability may have current and future financial implications that should be factored into investment decisions. A multitude of factors determine a stock’s ESG rating. By understanding how a company is rated, you can make confident investments that align with your long-term priorities. For more help managing your investments, consider working with a financial advisor.

What Is an ESG Rating?

An ESG rating evaluates the level of environmental, social, and governance risk exposure. Essentially, it tells investors how sustainable a company’s business operations are. Therefore, a high score would indicate to investors that the company either has values that they deem favorable or is proactive about guarding itself against environmental or governance risks such as pollution.

Investors may pause for concern with companies with lower ESGs because this might be less favorable for the investors’ portfolio and long-term financial goals.

Factors that Determine the ESG Ratings

When a company has a favorable ESG score, it means that the entity is doing well managing its environmental, social, and governance risk compared to other companies. On the other hand, a poor ESG score means that the entity isn’t doing so well and has unmanaged exposure to these risks.

When referencing the ESG rating, you usually hear the MSCI ESG referred to. The MSCI ESG ratings range from leaders (AAA,AA), average (A, BBB, BB) to laggard (B, CCC). Not only does MSCI rate companies but they also rate equity and fixed income securities, loans, mutual funds, ETFs and countries.

The MSCI ESG score is based on 10 categories which break down as follows:

Environmental Pillar

• Climate change impacts the ESG score by measuring carbon emissions, product carbon footprint, financing environmental impact, and climate change vulnerability.
• Natural capital comprises the topics of water stress, biodiversity and land use, and raw material sourcing.
• Pollution and waste are tied to toxic emissions, packaging material, and electronic waste.
• Environmental opportunities look at a company’s usage of clean tech, green building, and renewable energy.

Social Pillar

• Human capital comes from labor management, health and safety, human capital development, and supply chain labor standards.
• Product liability encompasses product safety and quality, chemical safety, consumer financial protection, privacy and data security, responsible investment, and insuring health and demographic risk.
• Stakeholder opposition includes controversial sourcing and community relations.
• Social opportunities regards access to communication, access to finance, access to health care, and opportunities in nutrition and overall health.

Governance Pillar

• Corporate governance is scored through the board, employee pay, ownership, and accounting.
• Corporate behavior is defined through business ethics and tax transparency.

How MSCI Score Companies and Securities

MSCI evaluates companies through a rigorous, multifaceted process that leaves them with a numerical score, ESG rating, and comparative assessment with others in their respective industry.
Companies earn a rating between 0 and 10 for 80 exposure metrics and 270 governance metrics. Higher scores reflect that a company is taking more effective action to mitigate risk. For example, Coca-Cola’s efforts to mitigate water stress significantly impact their scores. Therefore, this would be a vital issue for the company.

Each vital issue has a timetable and possible impact that the MSCI uses to determine its weight. Issues that will take five or more years to have a negligible impact get a slight weight, while issues that have meaningful impacts two years out are weighted highly.

Issue scores and weights get integrated, and MSCI gives the company a score between 0 and 10. Then the score is adjusts depending on the industry. Depending on performance, the company is designated as ‘Leader,’ ‘Average,’ or ‘Laggard.’

ESG Ratings for Companies

The appearance of overlap in the numerical score ranges is due to rounding error. The 0-to-10 scale is divided into seven equal parts, each corresponding to a letter rating.

Why Does the ESG Score Matter to Investors?

The ESG score is just one factor investors can use to determine which investments are best suitable for their portfolio. So, if you want to add this analysis to make a better-informed investor decision, here are some tips when incorporating the score:

• Swap out financial analysis with the ESG rating: The ESG score may give you a better understanding of the potential risks a certain company or security faces in the future.
• Use the ESG score for a barrier entry. For investors passionate about companies that are focus on sustainability and being a good corporate citizen, you can use the ESG score to scan potential investments. Essentially, if they don’t meet your criteria, you won’t explore them any future.
• Evaluate companies already in your portfolio with the ESG score. Assessing the ESG scores of companies already in your portfolio will help you identify any red flags. You can then take a closer look at any changes that occurred.

Example of ESG Rating

Starbucks (NASDAQ: SBUX) has an average MSCI ESG rating of BBB. Factors such as interns of corporate governance, raw material sourcing, and nutritional opportunities make Starbucks an “ESG leader” in this category among peers in the restaurant industry. Regarding carbon emission, it scores in the average category.

But, when it comes to safety, quality, and supply chain management, it ranks as a “Laggard.” However, Starbucks ranks ahead of other big names such as McDonalds (BB), Burger King (BB), and KFC and Pizza Hut owner Yum! Brands (BB). On the other hand, Starbucks falls behind companies like Compass Group (A) and Ocado Group (A).

Consequently, if you want to invest in Starbucks, you may want to take a deep dive into their supply chain management concerns and how that could impact your returns in the future. Understanding these risks will help you assess if Starbucks is the right choice for your portfolio.

The Bottom Line

Highly ranking ESG stocks reflect sustainable, fiscally responsible business decisions that provide better results for the company and the investor. Company behaviors that decrease risk and increase return are always good news for investors looking to improve their portfolios. Therefore, adding ESG ratings to your investment assessment can help you make better investing decisions.

Tips for Investing

• Consider talking to your financial advisor about the benefits and potential drawbacks of using an ESG investment strategy. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Keep in mind that there are different ways to pursue ESG investing, something that is becoming more popular. You could purchase individual stocks, for example, or invest in ESG mutual or exchange-traded funds. If you’re considering ESG mutual or exchange-traded funds, take time to look under the hood at the underlying investments. This way you can make sure the holdings create enough diversity to avoid over exposing yourself to company or sector.

Photo credit: ©iStock.com/Khanchit Khirisutchalual, ©iStock.com/Drazen_, ©iStock.com/Daniel Balakov