FUTURE OF INVESTMENT RESEARCH

Understanding how ESG scores are measured, their usefulness and how they will evolve

Leon Saunders Calvert profile with office in background

Leon Saunders Calvert

Head of Research & Portfolio Management

While environmental, social and governance scores are increasingly debated in the financial industry, pinpointing what they actually measure can be less clear. The layperson may legitimately expect that an ESG score provides an overview or rating on how ethical a company or its products are. This is not necessarily the case. Refinitiv ESG scores, for example reflect a relative performance based on fundamental ESG attributes which are publicly disclosed and auditable. It is in this context that we continue to call for ESG data to be treated as objective and fundamental data, not categorised as merely alternative data or dependent on subjective opinion. In shaping the debate, we need to examine the key definitions.

  1. ESG is an aggregate term that covers a range of thematic issues and measures which are non-financial, although they may be financially material. They do not necessarily correlate with one another. For example, a company’s carbon footprint does not necessarily correlate with its diversity and inclusion practices, its employee rights principles or its resource usage. A single ESG score cannot capture this complexity.
  2. ESG data and the disclosures that companies make have mostly focused on a company’s operations rather than its products and services or its supply chain. This is necessarily the case. It is much harder to expect companies to be able to report on the social impact of their products and services in an objective and measurable way. However, this approach can lead to counter-intuitive outcomes unless the focus of ESG data is clearly understood (consider the example of Tesla scoring relatively poorly on ESG criteria).
  3. We may assume that ESG scores can measure the ESG risks a company faces, the risks a company poses to the environment and society or the correlations on long-term performance of a company. Although we may want an ESG score to measure all these areas, they are not the same, and a single score cannot represent all of them.

This opens up an important debate around whether ESG data, sustainability and impact are synonymous with each other.

What is an ESG rating or score?

Refinitiv ESG scores measure a company’s relative performance on fundamental ESG attributes, commitment and effectiveness across E, S and G factors. ESG scores measure company operations, practices and effectiveness.

A single ESG score provides an overview of a company. This may be a single letter or figure that categorises a company and tells us how it is performing based on environmental, social and corporate governance business practices. However, while a single-score approach can appear superficially advantageous, it can also have drawbacks.

Investment managers, for example, may want to access granular ESG data that high-level ESG scores do not detail. We can overcome this lack of detail with an approach based on pillar and category scores covering each of the major themes within ESG and offering customers the ability to create proprietary custom scores using their own weightings and applying these to our underlying fundamental dataset.

As standards across ESG scores and sustainable investment practices develop and begin to be implemented, it’s important to acknowledge materiality within scores and across industries. Fuel efficiency, for example, has a bigger impact on an airline’s bottom line than it does on an investment bank’s, a consideration which must be incorporated into the methodology of an ESG score or ranking.

However, ESG scores are not the final word on scoring or ESG assessments. At Refinitiv, we provide an ESG score related to company-disclosed data and we also provide controversy scores. Furthermore, we carry exclusions data on companies, which do not affect the score – due to a lack of an objectively standardised way to do this – but which can be extremely important for investment decision making.

Our customers extensively use exclusions data to screen out exposures and practices that they want to avoid or weight against, including revenues from tobacco, alcohol, gambling and arms manufacturing, for example.

When examining a company’s self-disclosed ESG attributes, in many instances we are likely to see a different result than from a score that incorporates the impact of controversies. For example, the ESG performance for FAANG – Facebook, Amazon, Apple, Netflix and Alphabet (formerly known as Google) – companies highlights a 26.9 difference between ESG scores and ESG controversy scores.

FAANG companies: ESG scores and ESG controversy scores

Source: Refinitiv ESG database

Using controversies based on news and social media enables us to capture an alternate view of ESG efforts on a frequent basis.

What an ESG score is not

It’s important to note that an ESG score is not equivalent in practice to a rating like a credit score, which clearly outlines the likelihood of a company defaulting on its credit repayments. An ESG score is more nuanced than a credit score.

ESG scores do not provide an objective view of a company’s ethical position, its products or services. At Refinitiv, we endeavour to create objectivity and transparency around our scoring methodology, and attempt to avoid subjective opinions.

We rely on data derived materiality weighting across industries and countries to assess the importance of metrics and how they contribute to the scoring calculation.

If investors are looking to incorporate an ‘ethical view’ into their strategies, then negative screening in the investment-selection process – usually based on exposure to ‘undesirable’ industries, products or services – is a good start and one that our data supports. However, information on the impact of products and services on society and the environment, and how to objectively measure this, is still evolving.

The EU Taxonomy requires companies to report on the proportion of revenues (and opex and capex) that are ‘green’. This is likely to be an important step in the direction of having comparable data on the impacts of products and services, above and beyond company operations.

It is one that Refinitiv and FTSE Russell, both LSEG (The London Stock Exchange Group) businesses, have already built for with our Green Revenues and EU Taxonomy reporting tools.

These tools are currently separate from our ESG scores, which measure relative ESG performance of company operations. Investors need a view across both areas, operations and products and services, in order to establish a more comprehensive picture of the overall sustainability footprint and business model of a company.

How ESG data and scores are developing

Alongside the challenges that ESG scores pose, the financial industry is also struggling with the lack of standardisation of basic ESG data.

Currently there are no agreed standards of what ESG data should be disclosed and no single reporting standard for this disclosure.

Standardising scores is appealing in principle, but given the level of innovation and maturity still underway in the market, standardising scoring systems too early might have the opposite of its intended effect by limiting what ESG data can be and how it could be used.

Given that a clear determination of what constitutes ESG data doesn’t exist, it’s not surprising that different data providers that collect different data on ESG in different ways don’t always correlate highly with one another. Certainly, a focus on standardising core disclosures and reporting standards is an underpinning consideration which is worth getting right first.

Different market participants expect different things from ESG scores, including the impact made by a company on the environment and society, the ESG risks a company faces and the identification of correlations between ESG factors and company performance.

Arguably transparency of scoring methodology should, in the near term, be the primary focus for regulators and the financial industry. This would promote innovation and cognitively diverse approaches to the problem, while forcing transparency on what scores represent, and allow users of the scores to determine what best suits their needs for which purposes.

Refinitiv’s role in the evolving ESG universe

At Refinitiv, we believe that ESG data should be treated as fundamental data, objective rather than subjective or opinion-based, and that ESG scores need to be open and transparent with what they are scoring and how.

However, there needs to be a recognition of the still-maturing approach to company disclosures and a need for industry-wide standards.

We’re firmly committed to continuing to help evolve the data and methodologies in the sustainable investing universe and view the fact that work in this space is incomplete as a challenge and an opportunity rather than a reason for cynicism or pessimism.

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