Measuring success: an independent guide to ESG ratings

JP Morgan_Zak Denny_What is an ESG Rating

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An Environmental Social and Governance rating or ESG rating, is a score that's meant to reflect a company's exposure to, and management of ESG risks that can impact performance. So that's going to look very different for each company. Exposure to ESG risks is influenced by the sector and geography in which a company operates. So for example, if you're an oil and gas company, you're likely going to have higher exposure to environmental risks than a tech company might.

How well you manage those ESG risks is influenced by a company's public policies, procedures, and commitments. For example, a company's privacy policy or code of conduct will very likely impact its social score. ESG ratings are really intended to provide a single score updated at least annually and generally comparable across industries that reflects a wide range of ESG topics.

There are a few ways ESG ratings are used. First, investors often use them to determine what companies to invest in, or help them compile an ESG index. Second, businesses may look at them to determine which vendor to use or where to source their raw materials.

ESG ratings are often compared to credit ratings. One key difference is that credit ratings are paid for by the entity being rated whereas for ESG ratings it's a subscriber pay model where the user of the rating pays and the entity being rated will get a rating whether they want one or not. Another important difference, is credit rating agencies are highly regulated whereas regulation for ESG ratings is only just beginning to be considered.

ESG ratings are non-standardized and each rater will have its own methodology. Some focus more on ESG risk while others focus more on ESG impact. A few key differences between raters could be what ESG factors they consider? How they assess those ESG factors? And how they weight those ESG factors?

It's really important to engage with ESG raters to better understand their methodology and to communicate to them everything that your firm is doing in the ESG space. Another tip is to speak with customers, suppliers, and investors to understand whether they're using ESG ratings, and if so, how? That can really inform your ESG rating strategy.

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