The Policy Greenhouse

Over the summer, I sat down with a finance professor at a leading university and had a conversation with him about ESG scoring, and we discussed how ESG scoring worked as well as how it is used in the world today. During the beginning of the conversation, we covered how ESG scoring came about. Emerging in the early 2000s from a UN environmental finance initiative, students who were working with this initiative collaborated with the UNPRI (UN Principles on Responsible Investment, a body created by the UN Secretary-General that helps qualify ESG scores) and proposed the concept of using Environmental, Social, and Governance metrics and goals to qualify investments. The primary concept behind using ESG scores to set goals for companies to work towards was “who cares, wins”. Meaning that regarding the companies who would work toward these ESG goals, their motivation to do so is that paying attention to ESG factors will help your company have a competitive risk advantage over others, as paying attention to ESG factors would help limit any investment risks regarding the future prospects of a company. 

The use of ESG scores in the market is slowly developing over time, and has reached a point where certain ESG rating companies are taking the lead in the field. The professor I spoke to explained that there is no currently agreed upon criteria used in ESG scoring by companies, but there are reliable companies that are beginning to emerge in the field of ESG scoring with their own sort of criteria. There are two companies in particular that he mentioned, MSCI (Morgan Stanley Capital International, an Investment Firm) and Sustainalytics (they are entirely an ESG scoring company). These two companies differ their rating systems by taking different approaches to rating industries via something called a  “materiality matrix”. By rating the materiality that different companies in different categories like carbon emissions, ESG rating companies are able to determine the investment risk that a company poses based on how much it follows ESG standards. The examples he provided of a company that would have a low ESG score were an oil company or a cigarette company, and both of these companies would have low ESG scores because they did not pay attention to the adverse effects of smoking or extracting. This could lead to litigation against the companies, which would negatively impact the companies growth. 

Near the close of our discussion, we also covered the criticisms that many people bring against ESG scoring. There are many criticisms that ESG scoring is unreliable, as the lack of a standard criteria for rating means that the scores cannot be taken seriously. The professor specifically talked about a study that mischaracterized the ratings systems as inaccurate, as the study put forth that ESG scorers would give oil companies low scores all the time and tech companies high scores all the time. This study did not take into account industry-adjusting ESG scores, that is, comparing tech companies to tech companies and oil companies to oil companies. This approach of comparing companies within the same industry allows for the creation of reliable criteria, and is the driving reason behind the emergence of reliable ESG scoring companies.