What are ESG fund ratings?

Key takeaways

  • Managers and rating agencies use ESG considerations to develop ratings or scores for companies, bonds and investment funds.
  • ESG scores can differ widely between managers and rating agencies because the data, methodology and weights can all differ.
  • ESG scores can be used to develop ESG indices.
  • ESG index providers may exclude certain stocks and give higher or lower weightings to securities depending on their ESG score. Some try not to diverge too much from a parent index when it comes to sectors or regions represented in the index.
  • Some indices have targets to, for example, bring about a reduction in the carbon emissions of the securities they hold.

There are many factors to consider when investors and fund managers use environmental, social and governance (ESG) considerations to assess whether to invest in a company or not.

In addition, there are many ways in which to measure a company’s ESG factors – such as its carbon footprint or emissions, it’s employee satisfaction or the diversity of its board.

Companies may report on their own ESG factors in their Integrated or Sustainability Reports, but investors and fund managers will typically seek to validate these to ensure the company is not over-stating them.  

Investors and fund managers often rely on an ESG score that is comprised of a variety of measures of the ESG factors.

These scores are used to rate how well a company is performing on ESG factors and to rank them relative to other companies.


Rating agencies

Some investment houses have developed their own ESG scores, while others rely on methodologies and scores devised by rating agencies or index providers.

Some rating agencies have specialised in rating companies and funds on ESG and sustainability scores.

However, the way in which companies and funds are rated and the scores they get differ between rating agencies and managers.

Different agencies and managers use a variety of methodologies and data, and assign different weightings to the measures they use.

This means a company may, for example, be rated badly by one agency and better by another, depending on which measures, data and weightings are used to score the company.

One may give more weighting to the carbon footprint while another offsets this with work done to mitigate environmental damage. Another may have its own way of measuring a company’s impact on climate change.

When considering the well-being of the employees of a company, some agencies and managers assign more importance to health and safety than to diversity.

Some ratings focus on the impact and sustainability of a business using the 17 Sustainable Development Goals (SDGs) developed by the United Nations with a view to achieving a better and more sustainable future for everyone.


What is an ESG index?

An ESG index may be based on a parent index, but with the weightings, the shares or other securities tweaked on the basis of an ESG score.

This kind of ESG index is typically based on an existing index of a market, such as the MSCI World All Countries index – known as the parent index.

In some cases, the parent index is screened to exclude some of the shares in that index on the basis that they are involved in certain defined activities, such as the manufacture of weapons.

The remaining shares that make up the index after any screening are then given an ESG score.

Those with higher scores are given higher weightings than those with lower scores.

Each index provider decides how to assign those weightings and how to ensure that the ESG index still represents the industries and regions that were in the original index in order to deliver returns that are not lower than those of the original index.

Other indices are built on the basis of ESG criteria without reference to a parent index of the market. For example, an index that focusses on companies that advance the United Nations Sustainable Development Goals or an index that focusses on companies that are finding solutions to climate change. Some indices are made up of companies that support a number of ESG themes, such as clean technology, green real estate and sustainable forestry.

Some indices are subject to regulations that prevent them from dumping carbon intense industries such as mining for those that are carbon neutral.

Regulators have realised that the world will not meet its climate change goals if carbon intense industries are dumped from ESG indices. They realise that these companies need capital to transition away from high carbon use.

Similarly, there is a realisation that moving money away from countries whose economies are dominated by carbon-intense industries – particularly those in emerging markets – will not solve the world’s environmental or social problems.

Indices with targets

Some ESG indices tracked by global or regional funds may comply with European Union standards for Climate Transition Benchmarks and Paris-Aligned Benchmarks.

This means they agree to reduce the average exposure in the index to companies emitting greenhouse gases by a certain amount each year, without introducing a large tracking error relative to the parent index.

They may also exclude certain shares, such as those involved in controversial weapons, those involved in controversies, tobacco or fossil fuel power generation.