ESG ratings, ESG scores and ESG risk ratings

A credit rating answers one clear question: how likely is this borrower to default? Every credit rating agency is trying to measure the same thing, so their ratings usually agree.

ESG ratings are different. "ESG" covers dozens of issues, from carbon emissions to board independence, and there is no single outcome that all raters are trying to predict. So the products that go by the name "ESG rating" actually measure different things:

• Some measure how well a company manages the ESG risks that matter most in its industry, compared with its peers.
• Some measure how much ESG risk is left after the company's own management efforts, on an absolute scale.
• Some give a broad performance or disclosure score across many indicators.

Before using any ESG rating, you need to know which of these it is. A company can rank well on one and poorly on another without anyone being wrong.

Three main families

Coverage is large. MSCI says its ratings cover more than 17,000 issuers (June 2024), and Sustainalytics says its risk ratings cover more than 16,000 companies.

Steps in building a rating

1. Classify the company into an industry or sub-industry.
2. Pick the material issues for that industry. Carbon and water matter most for cement; data privacy and talent for IT services; product quality and access to medicines for pharma.
3. Collect data from the BRSR and annual report, sustainability reports, questionnaires sent to the company, regulators, news and NGO reports, and the rater's own estimates where data are missing.
4. Score each issue, usually on two sides: how exposed the company is, and how well it manages the issue through policies, targets and actual results.
5. Weight the issues. Weights differ by industry and by rater.
6. Adjust for controversies, such as accidents, fines or fraud allegations.
7. Normalise the result within the industry (for relative ratings) or keep it on an absolute scale (for risk ratings).
8. Review and publish, then monitor for new events between full reviews.

SEBI's six rating products in India

Under SEBI's rules, ESG rating providers (ERPs) registered in India offer six products at a minimum:

• ESG Rating, which blends assured and non-assured data.
• Transition or Parivartan Score, which looks at the speed and size of a company's efforts and investment towards net zero, and its improvement over time.
• Combined Score, which draws on both.
• Core versions of all three, based only on assured data, mainly the BRSR Core indicators.

Scores are given on a scale of 0 to 100, with a matching rating category. ERPs must also consider a minimum set of India-specific parameters, such as job creation in small towns, sourcing from MSMEs, gender wage gaps and votes by non-promoter shareholders against related-party transactions. The SEBI's Rules for ESG Rating Providers guide covers these rules in detail.

Reading a rating report

1. Date and data year. Many ratings rest on data that is a year or more old.
2. Material issues and weights. Check that they match your own view of what matters for the business.
3. Peer group. A "leader" in a weak peer group may still have high absolute risk.
4. Score drivers. The few issues that move the rating most.
5. Controversies. Whether a recent event has been reflected yet.
6. Business model. Whether the company paid for the rating (issuer-pays) or investors did (subscriber-pays).
7. History. The direction of change, not just the level.