ESG Score and ESG Rating - how to use

ESG* integration – What is the main value of an ESG score or ESG rating?

ESG score or ESG rating vs Credit rating?

Some consider that an ESG score or ESG rating should be used and treated as a Credit rating. 

The first question then is how do you use a credit rating? It is an indicator if risk level, hence it impacts spread levels and meets risk tolerance hurdles in portfolio inclusion. Companies would like it as high as possible to access cheaper financing. Unless of course the costs and requirements are not possible given the activity or the financial resources of the company.

An ESG score or ESG rating is also an indicator of risk but limited to non-financial risks. 

The current focus on ESG score, ESG rating and ESG integration

There is a lot of focus on this now and specific reporting is required in many countries, particularly in the EU. The focus is high because there is a clear consensus that we’re in a climate crisis that will have impact on companies, creating risks and opportunities, mainly due to societal and regulatory changes. The reason for the extensive EU reporting requirements is different, this is mainly to steer capital in the Paris agreement goal direction and, this is no secret, also to surface the “shameful” investing.  

As the real ESG integration comes along, and we’re still far from real ESG integration despite many investors claim they practice this, an ESG score will have a more and more important impact on forecasted P&L, Balance sheet and also on required risk premiums for companies.

Bonds vs Equities

The credit rating will ultimately include the ESG risk for the bonds, but with the weakness that it will be based on the credit rating agency’s choice of model.

Now there is no such for equity, so there the ESG score or ESG rating will stand alone and hence look “bigger”.

It still has the same function though, it is a risk indicator, but only covering a part of the risks, the extra financial risks.

Can ESG research be dehumanised?

Nowadays, most new businesses have to be based on numbers, has to be scalable globally, on the web and preferably has to be exploitable without further treatment. The more AI can deal with it the better. “Give us a quick, easy solution to answer to the requirements…”

The “it is all about data” is a worrisome trend, it means that most of the research will be based on numerical and measurable standard approaches. This to the opposite of woman- or manmade holistic and strategic research of extra financial factors, that can grasp all the “other“ non-numerical issues that are typical for ESG research. The financial analysis of companies is still in 2021 made by financial analysts (persons) and this must also be the case for ESG research of quality. Actually, there is no quick fix.

Conclusion: The main value of an ESG score or ESG rating

So, finally the answer to the initial question. A numerical ESG score or ESG rating is merely an indicator that you as an individual portfolio manager should use as a yard stick or alert to ensure you understand the ESG risks of an individual investment opportunity that you either consider or already have in your portfolio. 

If the ESG score or ESG rating is very low, I recommend to dig into the case to understand the reasons for the low score or rating, then engaging with the company before investing. This to get clarity on the risks you would be exposed to by investing and also make the company address their residual ESG risk. If it is low, dig and engage as a shareholder or bond investor. If the ESG Score it mid-range or high it does not mean that you shall overlook it, read the ESG research to ensure you have a grasp of the ESG risk, and engage when you meet the company, but the urgency is naturally lower than for the companies with very low or low ESG score or ESG rating. 

And yes, it is only assessing part of the risk/opportunity picture, an important difference to a credit rating. Mabe the financial risk/opportunity is so good you would like to take on the high ESG risk, fair enough. But keep in mind how it will look in the upcoming required EU ESG reporting.

The main point with the ESG score or ESG rating is to ensure that you as a portfolio manager is aware of the extra-financial risks. 

“And staring at a number is not doing that for you” 

This is actually arguing for a “traffic light” system instead of a number based ESG score or ESG rating, as it would to a lesser extent represent a sleeping pillow. 

As usual, it is only serious quality work that will lead to outperformance over time, and then luck of course. I recommend going for the serious work.