How Do ESG Ratings Agencies Work – And Why Should You Care?

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If you are a socially-conscious investor, you may wonder who determines which companies are deemed “socially responsible” and what criteria is used. After all, one person’s view of social responsibility often differs radically from another person’s view. Socially responsible investing is a broad, often subjective, notion, so can it be objectively evaluated?

Enormous interest in socially responsible investing (SRI) by both individual and institutional investors gave rise to a relatively young, but fast growing, industry— environmental, social, and governance (ESG) ratings agencies. Today, there are a handful of established agencies using rigorous criteria to evaluate companies based on ESG metrics.

How Do ESG Ratings Work?

While each agency has its own specific approach, the overall broad framework evaluates a company’s “social responsibility” within these pillars:

  • Environmental: Covers issues such as climate change, renewable energy and sustainability
  • Social: Covers issues like diversity, labor relations, and conflict minerals
  • Governance: Covers matters such as management structure, board independence and executive compensation

The ratings process works much like company credit-rating agencies, such as Moody’s or Standard & Poor’s. These agencies rank companies based on financial factors. Results from credit agencies tend to be closely aligned, largely because the metrics they use are similar and well-defined.

ESG agencies, on the other hand, work with a host of non-financial data that cannot be delineated in the same manner as a more straightforward financial analysis. This means they work with less well-defined criteria, so scores for a single company can sometimes vary between agencies. ESG scoring is an evolving discipline — adopting a common language and reporting requirements are part of that ongoing process. However, it will likely be some time before there is any structured global methodology. The key, if you’re looking for an ESG ratings firm, is to find a credible company with a robust research process you understand and agree with.

Sustainalytics: An Example

To illustrate the basic process, we’ll look at one agency’s approach to ESG ratings, Sustainalytics.

Sustainalytics is an established global leader in ESG research and has a ratings history spanning more than 25 years. The agency serves more than 450 clients and has offices in 14 cities around the world.

In making their assessments, Sustainalytics evaluates ESG characteristics based on three key indicators, including:

  • Preparedness: Assessments of company management systems and policies designed to manage material ESG issues.
  • Disclosure: Assessments of whether company reporting meets international best-practice standards and is transparent with respect to most material ESG issues.
  • Performance (both quantitative and qualitative): Assessments of company ESG performance based on quantitative metrics, such as carbon intensity; and qualitative assessments of company ESG performance based on the analysis of controversial incidents involving that company.

Sustainalytics covers approximately 11,000 companies across the globe and employs more than 170 researchers. According to the company’s website, “An ESG report for a single company includes qualitative analysis and commentary on the company’s ability to manage ESG issues; a summary of a company’s ESG performance with environmental, social and governance scores in relation to industry peers; and an overview of any ESG controversies, with access to a full controversy report.”

Sustainalytics uses metrics, as well as direct engagement with companies, which allows for feedback and a greater ability to assess transparency with respect to ESG issues. This process produces an ESG score, which investors can use to make decisions relative to their investment objectives.

Why Should an Investor Care About ESG Ratings?

Ratings agencies provide lots of additional analysis, and more information is always better. In fact, evidence indicates that ratings agencies help accomplish some of the social goals of ESG-conscious investors. For example, scoring helps motivate companies to create, adhere to, and disclose their ESG policies. And putting ESG issues on the radar for leadership at every company is part of the mission for many socially responsible investors.

Our Take

Correctly measuring socially responsible success starts with fully understanding how the securities in your portfolio were chosen and how they will be monitored going forward. At Personal Capital, we partnered with Sustainalytics for their ESG research and ranking metrics, and used this data to help create our socially responsible plan for Personal Strategy®. But the ESG scores are just a piece of the overall equation—you still need to figure out how to apply them in your portfolio. Personal Capital uses its own vetting process—taking a “best in class” approach to the US equity component of portfolios. We first remove all companies with ESG scores below their peer group average, and subsequently apply our Smart Weighting™1 methodology to the remaining universe. Smart Weighting is our proprietary investment approach that more evenly weights the factors of size, style and sector when compared to traditional cap-weighted indices. We then attempt to choose companies with the highest overall ESG scores. On average, our chosen US stocks have ESG scores above the 90th percentile relative to their domestic peer groups2.

If you would like to learn more about SRI or Personal Capital’s socially responsible plan for Personal Strategy, schedule an appointment with one or our advisors today.

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1. For complete description of Smart Weighting, read our white paper on Personal Capital’s Socially Responsible Plan for Personal Strategy

2. As of 1/31/2018

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Brendan Erne, CFA
Brendan Erne serves as the Director of Portfolio Implementation at Personal Capital. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.

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