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How Investors Interpret ESG Scores

Environmental, social, and governance sustainability data is growing in importance for many investors.

By Simon Turner

As more investors understand the performance-enhancing and risk-reducing benefits of investing in sustainability strategies, demand for high quality ESG data is rising. As a result, institutional and independent investors now employ at least one ESG rating platform in their investment decision-making process. Some use multiple platforms to ensure that they have access to more and better sustainability information. Understanding how investors apply ESG data and ratings is essential as the sustainable investment boom gathers momentum.

ESG scores play a primary role

Most professional investors have risk specialists working within their organizations. They produce and analyze data that breaks down risk across their portfolios according to a range of factors, including ESG issues such as board composition and waste management performance.

Measuring risk at a portfolio level is a useful and easy way for professional investors to gauge risk from a top-down perspective. This also highlights bottom-up risks about which the portfolio manager may not have been aware. So, the primary role of ESG data, for the investor, is to provide the background information necessary to create an accurate picture of ESG risks at a portfolio level. This means that the ESG scores which rating agencies ascribe to a company tend to be less relevant to investors than the granular ESG data behind the score. This detailed ESG data contributes most to an accurate portfolio view and is thus of most value for investment risk evaluation.

Once investors have a portfolio view of ESG risks, they typically assess the materiality of each ESG issue, particularly if it’s a standout risk. In essence, gauging materiality is the context which enables investors to make sense of ESG data. Some professional investors may also choose to form their own opinions of materiality based on their market experience. There is a vast array of materiality assessment resources available, such as those offered by the Sustainability Accounting Standards Board.

For example, a portfolio manager may discover that a prospective investment or portfolio company is performing poorly in the environmental area of water management. The manager may be aware that water scarcity is a growing global environmental threat and therefore a major investment concern. In other words, the materiality of water management is rising and will likely continue to do so. As a result, the knowledge that the manager’s portfolio is on the wrong side of an increasingly important market factor is valuable information which may cause the manager to adjust the portfolio to include companies addressing water scarcity rather than performing poorly in this area.

ESG data is also useful for stock analysis.

ESG data also plays a primary role for investors at the stock analysis level. Depending on how integrated ESG is within an investor’s investment process, the investment firm’s analysts will generally use the granular ESG data behind the scores to identify risks and opportunities that they should take into account in their investment analysis work.

For example, if a company an analyst is working on has been dragging its heels in lowering its carbon emissions relative to competitors and market expectations, this may raise a red flag. This data may lead to further investigation, and lead to the analyst developing a negative opinion of the stock.

ESG scores do matter to some investors.

While it’s clear that the most valuable ESG data for most investors is the detailed data on each issue, overall ESG scores also matter. One reason why is that investors who are less aware of sustainability issues may rely on these ratings as a summary measure of a company’s ESG profile. Some investors may be unaware of how subjective ESG scoring is, or of the wide range of scores assigned to a given company by different ESG rating agencies.

Looking forward, the growing importance of ESG data is here to stay as investors strive to access the most useful and actionable investment information. Some institutional and independent investors are likely to remain focused on interpreting high quality ESG data in-house. Others are likely to settle for overall ESG scores as a quick measure of sustainability in various areas. No matter how one approaches these issues, it’s essential to become aware of the opportunities for companies and investors to benefit from the growing importance of high quality ESG data.

At The Global Imprint, we’re here to help you make sense of the ever-evolving ESG landscape. Reach out to our team to set up an introductory call or complete our ESG Readiness Survey to see where your company stands in sustainability metrics.

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