By Jinsong Yang, Sustainability Specialist, TÜV SÜD
The term ESG (Environmental, Social, and Governance) was formally introduced in the 2005 landmark report “Who Cares Wins,” where 20 financial institutions responded to the call for “better investment markets and more sustainable societies” from former UN Secretary-General Kofi Annan. Since then, ESG factors have become the foundation for responsible investment, and an essential element in building a sustainable financial system. By incorporating ESG factors into the investment process, investors can form a more comprehensive picture of the enterprises they invest in, and identify material risks and opportunities.
Measuring ESG Ratings
ESG ratings refer to the quantitative scoring or grading of enterprises' information disclosure and performance concerning environmental, social, and governance factors by third parties. It represents the evaluation of the ESG performance and ESG-related risks of the capital market for enterprises. Increasingly, financial institutions are taking ESG ratings into consideration in the investment screening process. Therefore, a good ESG rating can help enterprises attract investors and reduce financing costs.
There are different ESG rating agencies, such as MSCI, S&P Global ESG, and Sustainalytics, who globally evaluate companies on their ESG risks and performance. Each of these agencies has its own rating systems and methodologies. They assess a company based on publicly available information, which is gathered from its publications, government database, financial institutions, media, or other stakeholders. A questionnaire may also be used to collect additional information from the company. It is noteworthy that most rating agencies focus only on issues that are material [YJ1] for that specific industry. Generally, the scores are given for each material ESG topic that may create significant risks and opportunities for the company, alongside an overall score. A company's relative performance against its peers may also be used to adjust the score to obtain a universal rating comparable across industries.
Improving ESG Ratings Through Information Disclosure
An ESG or sustainability report is an essential channel for companies to present their performance and progress in sustainability to both internal and external stakeholders. Moreover, it is one of the main references ESG rating agencies use to assess how well companies manage risks and opportunities concerning ESG matters. Therefore, to improve ESG ratings, companies should ensure smooth information disclosure and that the reporting is consistent with the rating criteria.
To improve the quality of reporting, first and foremost, companies should choose the right reporting standards. Currently, the standards published by the Global Reporting Initiative (GRI) are the most widely adopted sustainability reporting standards in the world. According to the GRI, its standards have already been voluntarily used by over 10,000 companies, including 73% of the world’s 250 largest companies. As the only global standards with an exclusive focus on impact reporting for a multi-stakeholder audience, the GRI standards allow organizations to identify and transparently disclose the impact they have on society, the environment, and their contributions toward sustainable development.
The GRI Standards consist of a set of modules and an interrelated framework, including universal standards (GRI 101 to 103), economic standards (GRI 201 to 206), environmental standards (GRI 301 to 308), and social standards (GRI 401 to 419). GRI 101 is the starting point for using the set of GRI Standards. It sets out the principles organizations should consult to understand how to report using the GRI Standards. GRI 102 is a general disclosure standard that covers information such as organizational profiles, strategy, governance, and stakeholder engagement practices. The management approach for each material topic needs to be disclosed according to GRI 103; the rest are topic-specific standards. To apply the GRI Standards in reporting, companies should comply with its principles (GRI 101) and report the general disclosures (GRI 102). Companies should then identify and report material topics within the indicated boundaries (GRI 103 - management approach and topic-specific standards). Finally, companies can present all information and references in the reports.
When disclosing financial risks and opportunities related to the impacts of the reporting entity’s activities, companies are advised to use the standards issued by the Sustainability Accounting Standard Board (SASB). The SASB has developed a set of 77 industry-specific sustainability accounting standards, including a minimum set of industry-specific disclosure topics likely to constitute material information.
Apart from the standards published by GRI and SASB, companies can refer to frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD), Principles for Responsible Investment (PRI), and the United Nations’ Sustainable Development Goals (UN SDGs), as well as national and local laws, guidelines from the stock exchange, and other relevant policies and documents.
In addition, stock exchanges such as the Hong Kong Stock Exchange, and government organizations such as the China Securities Regulatory Commission, encourage companies to conduct a third-party assurance to improve the quality of their reporting and increase information credibility. ESG rating agencies will also take third-party assurance into consideration when evaluating ESG or sustainability reports. Consequently, the number of companies choosing to have their reports verified by a third-party has continued to grow over the past five years.
Benefiting From ESG Ratings
Companies can use ESG ratings to assess their ESG performance, highlight material topics, identify risks, and integrate these findings into the corporate strategy.
ESG ratings are usually published on the rating agency’s website. Organizations can compare the ESG ratings to their peers to obtain an overview of their ESG performance. As ESG rating agencies usually use industry-specific key issues and weighting methodology to select the ESG risks most crucial to an industry, they typically have their own industry materiality maps for assessment. Companies can refer to these industry materiality maps to highlight issues that are most important to them. In addition, from a risk mitigation perspective, companies should identify the most material issues and focus on building a strong management structure around these issues. By monitoring topics that are important but not currently addressed, companies can identify potential risks and areas for improvement. Finally, by implementing significant social and environmental topics into corporate strategy and embedding management of sustainability issues into the broader business process, companies can increase their resilience and build stronger market competitiveness.
In conclusion, ESG is becoming mainstream worldwide. With new policy instruments such as the EU Sustainability Reporting Directive and the US SEC Climate-Related Disclosure Proposed Rule coming into force, more companies are obliged to disclose the impact of sustainability issues. This includes the company value, as well as the economic, environmental, and social impact of the company’s activities. In addition, the scope of information disclosure continues to expand to the broader value chain of the company. As these new changes take place, ESG rating agencies will maintain the engagement with global ESG reporting standard setters and initiatives to ensure alignment on key ESG topics. Through information disclosure consistent with these global reporting standards, companies can obtain a more comprehensive assessment of their ESG performance from the rating agencies.
Source：Ticker 2022 Summer
