Image above: “ESG rating” © Mark B Pixels, 2024

ESG rating

Importance, application & the future of ESG ratings

In an increasingly environmentally aware and socially responsible world, ESG ratings are becoming more and more important. Companies and investors are recognizing that financial performance alone is no longer enough to ensure long-term success. Instead, environmental and social responsibility and corporate governance with integrity are becoming key factors for sustainable success. In this blog article, we explain what an ESG rating is, how the rating process works, why ESG ratings are becoming increasingly important for both companies and investors and venture an outlook for the future.

What does ESG mean?

Environmental, Social & Governance

E

Environmental

Image above: “Intact nature” © Olga Gavrilova, 2024

Environmental: This ESG pillar relates to the environmental practices of a company. Relevant are, for example:

Use of natural resources
Energy consumption & efficiency
Greenhouse gas emissions
Waste management & recycling
Effects on the ecosystem & biodiversity

S

Social

Image above: “Diversity and inclusion in the office” © Dragana Gordic, 2024

Social: This aspect encompasses a company’s social commitment and its interaction with people and communities. Important points are:

Fair working conditions
Occupational safety
Diversity & inclusion
Customer & data protection
Respect for human rights along the supply chain

G

Governance

Image above: “Business ethics” © Andrzej Rostek, 2024

Governance: This area covers the structures and processes of corporate management. The topics include:

Independence & diversity on the Management Board
Measures against corruption & bribery
Remuneration of executives
Transparency in decision-making & reporting
Compliance with legal regulations & ethical standards

What is an ESG rating?

Sustainability rating

Image above: “ESG rating in a highly simplified illustration” © Luana AG, 2024

An ESG rating is an assessment of a company, state or organization based on the above-mentioned criteria. While ESG reports are used by a large number of stakeholders, ESG ratings are aimed almost exclusively at investors and thus enable a comparison with competitors. The reasons for preparing ESG ratings can be manifold:

Investment decisions: Investors use ESG ratings to evaluate a company’s sustainability profile in order to then invest in companies with positive ESG practices, for example, or—according to Hypovereinsbank—“to evaluate listed stock corporations on their own initiative so that they can be included in sustainability indices”.
Risk management: Companies with high ESG ratings are often considered less risky, as they may be better prepared for future regulatory changes (e.g. stricter environmental laws) or social expectations.
Reputation & competitive advantage: Companies can be assessed in the form of an ESG rating, as a high ESG rating can strengthen a company’s reputation and make it more attractive to customers, employees and business partners. In addition, the fact that weather events caused by climate change are expected to cost companies 1.3 trillion dollars by 2026 has prompted many companies to prioritize ESG management.

Sources:
HYPOVEREINSBANK (2024): “ESG-Rating für mehr Orientierung”, last accessed on 2024/09/30.
FORBES MEDIA LLC. (2021): “Climate Change Will Cost Companies $1.3 Trillion By 2026”, last accessed on 2024/09/30.

Who conducts ESG ratings?

Rating agencies & financial service providers

ESG ratings are carried out by various specialized agencies and organizations that focus on evaluating companies in terms of their sustainability performance and social responsibility. Here are key categories and examples of leading providers:

Rating agencies

Well-known ESG rating agencies are ISS ESG, Sustainalytics and MSCI ESG Ratings. These agencies analyze a large number of companies on a global scale and evaluate their environmental, social and governance practices. They use extensive data sets and proprietary methodologies to objectively assess the ESG status of a company.

Financial service providers

Large financial service providers and index providers such as Bloomberg and FTSE Russell have also developed their own ESG rating models. They integrate ESG data into their financial products to provide investors with more comprehensive information to make informed decisions. These service providers use ESG ratings to develop sustainable indices that offer an alternative way to evaluate companies according to traditional financial metrics.

Non-governmental organizations (NGOs)

Some NGOs and independent organizations, such as CDP (Carbon Disclosure Project), also play an important role in the assessment of ESG factors. CDP collects data from companies on their environmental performance, particularly in relation to climate change, water and forest management. These assessments help to hold companies accountable and incentivize improved environmental practices.

Academic institutions & research institutes

Academic research institutes such as the Sustainable Finance Lab or the Global Reporting Initiative (GRI) also contribute to the analysis and evaluation of ESG practices. They develop standards and frameworks that can be used as a basis for ESG ratings. They also make an important contribution to the further development of the theoretical foundations of ESG assessments.

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How are ESG ratings prepared?

Data sources, evaluation methods & weighting

The preparation of an ESG rating is a complex process based on the analysis of numerous data points and factors and is often not standardized. Agencies use different methods to assess the performance of companies in these areas. Here is a detailed overview of the key steps and approaches involved in producing an ESG rating:

Image above: “Data sources for ESG ratings” © Luana AG, 2024

Data sources

The basis of an ESG rating is extensive data collected from various sources. These include:

Company reports: Many companies voluntarily publish sustainability reports or ESG reports in which they disclose their environmental and social practices as well as governance structures. These reports provide detailed information on topics such as CO₂ emissions, diversity measures and ethical corporate governance.
Regulatory reports: In some countries, companies are required to disclose information on environmental and social practices as well as governance issues. These mandatory disclosures are another source of data for ESG ratings.
Media & news sources: Rating agencies continuously monitor news and media reports on companies to gather information on incidents such as environmental pollution, labor disputes or corruption scandals.
Surveys & direct contacts: Some ESG rating agencies contact companies directly to obtain additional information that is not publicly available. These interviews can help to improve data quality.

Valuation factors

An ESG rating covers a wide range of topics, which are divided into three main categories: environmental, social and governance. The weighting of these categories can vary depending on a company’s industry and business model.

Weighting & industry-specific differences

Not every company is rated according to an identical scheme. ESG rating agencies often adapt their assessment models to the specifics of the respective industry. For example, the environmental impact is more important for companies in the energy or chemical industries than for service companies, where social and governance aspects are weighted more heavily.

The weighting of environmental, social and governance factors varies depending on the industry and region. In the automotive industry, for example, CO₂ emissions and the use of renewable energies could play a greater role, while governance criteria such as risk management and compliance are more important in the banking sector.

ESG scoring models

The data and information are converted into an overall rating using a scoring system. ESG rating agencies use their own models to weight the individual factors and then aggregate them into a final rating. A points system is often used in which companies are given a score or a value between 0 and 100. Some agencies also use letter grades, similar to credit ratings (e.g. AAA, AA, B, etc.).

Transparency & Methodology

A critical issue with ESG ratings is the transparency of the valuation methods. Although many rating agencies publish general information on their methodology, the exact calculation basis often remains under wraps. This can lead to criticism, as it is difficult for external observers to assess the comparability and objectivity of the ratings.

Different weights & models

Another aspect that can lead to different ESG ratings for the same company is the fact that each rating agency uses its own methodology and assessment criteria. These differences can mean that a company is rated as exemplary in the area of sustainability by one agency, while it performs worse by another. This is particularly problematic for investors who rely on consistent and comparable information.

Manual vs. automated analysis

The process of ESG assessment can be both manual and automated. Some agencies rely on machine learning and artificial intelligence to extract and analyze data from reports and news sources. Others rely on manual analysis by experts to ensure a more thorough assessment. Automation offers the advantage of faster data collection, but can also lead to incomplete or inaccurate assessments if relevant contexts are not sufficiently considered.

How does the ESG rating process work?

From the company’s perspective

From the company’s point of view, the process is as follows (in generic terms, the process is usually broken down into even more detail and can vary):

Step 1: Data collection:
The company provides comprehensive data on ESG-related activities and policies. This includes CO₂ emissions, energy consumption, working conditions, diversity, supply chain transparency and compliance.

Step 2: Analysis by rating agencies:
ESG rating agencies analyze this data, compare it to industry-specific benchmarks and rate the company in the three ESG categories.

Step 3: Evaluation & scoring:
Based on the analysis, the company receives a rating or score that reflects its ESG performance. Higher ESG scores indicate stronger sustainability performance.

Step 4: Feedback & improvement:
Companies use the rating to identify weaknesses and develop strategies to improve their ESG performance, which is also important for investors and other stakeholders.

What is Luana AG’s ESG rating?

Currently still in the rating process

We are currently in the middle of the rating process with ISS ESG. ISS ESG is the environmental, social and governance (ESG) division of Institutional Shareholder Services (ISS), a global consultancy for investors. ISS ESG provides data, analysis and services in the field of sustainable finance to help investors integrate ESG criteria into their investment decisions. Our documents have all been submitted and are currently under review (as of October 2024). As soon as we have received the result, we will publish it on our website.

We have completed 3 milestones (out of a total of 8 review process steps with ISS) and are still in the rating assignment process.

ESG rating progress of Luana AG: 38%

Status: October 2024

The future of ESG ratings

Development of uniform & transparent valuation standards

ESG ratings are playing an increasingly important role in investment decisions and company valuations. They help to assess sustainability performance in the environmental, social and corporate governance areas and create transparency. However, there are many challenges, as there are currently no standardized assessment methods. The lack of standardization and the large number of rating agencies and different assessment methods lead to inconsistencies and make it difficult to achieve clear and comparable results. In future, the focus will be on developing uniform, transparent valuation standards in order to provide investors with better guidance and make companies more sustainable. According to Deloitte, “the International Accounting Standards Board (…) is currently developing a transparent, standardized ESG framework for financial reporting that is expected to change the way companies currently report on material ESG issues”. A move towards greater consistency and transparency is essential to optimize ESG assessment, so we support the call for consistent, objective and transparent ESG assessments.◼

Source: DELOITTE (2024): “Die Zukunft von ESG-Ratings”, last accessed on 2024/09/30.