Evaluating sustainability: ESG ratings – what's behind them?


published on 17 november 2023 | reading time approx. 4 minutes

Sustainability is more present than ever, with a growing number of companies commit­ting to more sustainable business practices, ranging from reducing CO2 emissions to improving working conditions for employees. But what is sustainable and what is not is difficult to recognize from an external perspective. Various sustainability standards, such as the ESRS, GRI, DNK and EU Taxonomy, can be used to determine a company's own sustainability performance. However, sustainability rating agencies can also help to classify different companies. 

External rating agencies assess companies based on ESG-relevant key figures, risk and performance indicators, such as emissions to air, soil and water, the appropriate treatment of employees and sustainable business practices. These are aimed at a large number of stakeholders but are currently mainly used by investors and fund managers, as increasing attention is being paid to ecological, social and corporate policy aspects in the context of the financial market.  
Sustainability ratings can be used by companies and stakeholders to achieve a classification in the market. As there are various sustainability rating providers and methods of rating creation, the different types are exami­ned in more detail below. 

How do Ratings differ from one another?

The methods used to produce ESG ratings vary greatly depending on the provider and are therefore difficult to compare. The first difference lies in the commissioning of the ratings. There are ratings that are commissioned and paid for by companies and those that are not commissioned by companies but select the companies they rate on the basis of certain criteria. The advantage of commissioned ratings is that internal information to which the public does not have access can also be evaluated. The problem with non-commissioned ratings, on the other hand, is the lack of diversity of information, as only public sources can be used. A mixture results from cooperative ratings, which are not commissioned and therefore not paid for. They only work if the company cooperates with the rating agency and makes these internal sources available.  

There are also differences in the analysis and evaluation processes. The latter can be carried out by algorithms or purely manually. Data sources include sustainability reports prepared by the company itself, news or special events, external reports and, where applicable, internal reports. 

Insight into ESG Rating Agencies

The major differences in the methods used by rating agencies and the associated lack of transparency are also well known in the EU. In particular, the quality and reliability of ratings should be ensured through authoriza­tion and supervision by the European Securities and Markets Authority (ESMA). 
As the ESG rating market is highly dynamic and complex, the international reputation of the rating agencies is an important criterion for investors. There are a large number of different rating agencies internationally and throughout the EU. The following three rating agencies have the largest market share:  

  • Morgan Stanley Capital International (MSCI) 
  • Sustainalytics 
  • Institutional Shareholder Services (ISS) 

MSCI evaluates companies primarily in terms of their ESG risks and how well they are managed compared to their competitors. The classification is divided into “AAA-AA” - “LEADER”, “A-BB” - “AVERAGE” and “B-CCC” - “LAGGARD”. 

When assessing companies, Sustainalytics focuses on weighing up financial risks. A distinction is made between different categories: “Manageable Risk” and “Unmanageable Risk”. Manageable risk is also broken down further and divided into managed risk and the management gap. The “management gap” is characterized by the fact that these are risks that could be managed but are not yet managed. Together with the “unmana­geable risk”, this results in the “unmanaged risk”, i.e. the risk that is not managed. The final ESG risk rating is based on this. 

Institutional Shareholder Services (ISS) applies a wide range of around 100 rating criteria, including environmental management, climate change strategy and human rights. The rating system is in alphabetical order from “A+” to “D-”. ISS not only evaluates companies on their sustainability efforts, but also acts as a consultancy and proxy. As such, it exercises voting rights for large hedge funds and mutual funds and advises them on a wide range of sustainability issues (voting rights advisor). 

Furthermore, ecovadis is also a widely used sustainability rating, which is primarily used in the SME sector. Ecovadis is a platform that supports companies in evaluating and improving their sustainability performance. The Ecovadis rating system analyzes various aspects using a questionnaire adapted to the industry, size and country of the company. The methodology used is in line with international standards. Based on these assessments, companies receive a sustainability score and customized suggestions for improvement. 

Outlook: Challenges and Benefits

Even if the rating agencies take different approaches, there can be uniform benefits for the rated companies. Positive ESG ratings can be used to gain better access to green finance markets. ESG ratings form the basis for green financing instruments such as green bonds and sustainability-linked loans. Small and medium-sized enterprises (SMEs), which are not normally checked for creditworthiness and sustainability without their own initiative, can also use ESG ratings to set themselves apart from their competitors and potentially benefit from better lending conditions. Investors are also paying more and more attention to potential sustainability risks and are incorporating sustainability aspects and positive ESG ratings into their investment decisions. 
Furthermore, detailed ESG ratings can be used to evaluate internal sustainability processes and thus reduce sustainability risks in a targeted manner. Another advantage is the more credible communication of a company's own sustainability efforts to a wide range of stakeholders. ESG ratings can also be used by companies to gain an overview of the competition and to position themselves in the market. 
ESG ratings should be taken seriously by companies, also as they are primarily aimed at investors. Due to the lack of transparency in the assessment methods of different rating agencies, companies with low data availa­bility in the area of sustainability efforts may receive mixed ratings. The EU is already working on making ratings more transparent and therefore easier to use. The assessments of various rating providers should therefore be used in order to better classify the current market. 

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