The importance of ESG ratings for investment

With substantial interest and the growing importance of Environmental, Social, and Governance (ESG) criteria, investors require an objective way to assess a company’s ESG performance. ESG criteria help investors consider the ‘unmeasured’ or ‘unrepresented’ environmental, social, and governance topics when making investment decisions. These criteria reveal data that traditional financial analysis often overlooks, offering insights into a company’s sustainability in its broadest sense. As a result, several ESG Rating Agencies—such as Sustainalytics, MSCI, and FTSE ESG—assess companies worldwide on their ESG performance and make this data available to their clients. These ratings aim to help investors identify and understand financially material ESG risks to a business. 

Companies are evaluated based on publicly available information, including media sources and annual reports and scores are given for each material ‘E’, ‘S’, and ‘G’ topic, alongside an overall score. Investors use these scores as a proxy for ESG performance and as a result companies that perform well on ESG metrics are believed to anticipate future risks and opportunities more effectively, engage in long-term strategic thinking, and focus on long-term value creation. 

The impact of ESG ratings on investment

As investors continue to incorporate ESG scores into their strategies, ESG criteria have proven to be highly valuable, with ESG-focused portfolios consistently outperforming traditional portfolios. A study by Frontiers highlights that companies integrating ESG principles into their strategies tend to attract a broader range of investors prioritising sustainability and social responsibility. This can lead to increased capital flow and improved financial performance. Similarly, a meta-analysis of over 2,000 studies has confirmed that the economic and responsible case for ESG investment is tangible. 

Conversely, a poor ESG rating can have significant repercussions. If, for example, your company receives a poor rating from one ESG data provider, its stock may be labelled an ‘unsustainable asset’ by investors and excluded from portfolios. This exclusion, if adopted by multiple investors, can ultimately harm the company’s share price. In Europe, where most assets under management are invested in ESG funds or strategies with a sustainability focus, understanding and improving ESG scores year-on-year is crucial to maintaining investor confidence. 

ESG ratings as a tool for internal benchmarking and improvement

ESG ratings can also be a valuable internal benchmarking tool for guiding decision-making and improving sustainability performance. An external evaluation provides an independent view of your company’s ESG standing and its comparison with competitors. This perspective can be a powerful driver for change, motivating internal stakeholders to address areas of weakness and capitalise on strengths.

ESG ratings under scrutiny

Despite their value, ESG ratings have faced criticism for inconsistencies and a lack of standardisation across different providers (such as Sustainalytics, MSCI, and FTSE ESG). This variability has sparked calls for greater methodological rigour and transparency within the ESG rating industry. Standardising ESG assessment criteria through regulations can foster greater confidence in ESG ratings and support more informed investment decisions. 

On 19 November 2024 the Council of the European Union adopted a new regulation, targeting enhanced reliability and comparability of ESG ratings. This new regulation was initially proposed on 13 June 2023 by the European Commission (EC), focusing on: 

• Authorisation and supervision of third-party providers by the European Securities and Markets Authority (ESMA) 

• Separation of business activities to prevent conflicts of interest 

• Proportionate, principle-based organisational requirements 

• Minimum transparency obligations on ratings methodologies, objectives, and more detailed information to subscribers and rated companies 

• Transparency of fees and requirements for fairness, reasonableness, and non-discrimination 

• Allowing third-country providers to operate in the EU market under certain conditions 

The next step in this process is the publication of the regulation in the EU’s Official Journal, after which it will take effect 20 days later. Its application will begin 18 months after it comes into force. There are also discussions about how double materiality assessment methodologies could further shape ESG rating standards. 

Navigating ESG Ratings in the era of double materiality

The concept of double materiality is increasingly becoming more central to understanding the full impact of ESG factors on investment decisions and corporate performance. Double materiality goes beyond traditional financial materiality to encompass both the financial impact of sustainability issues on a company and the company’s impact on society and the environment. This dual perspective of impact and financial materiality is increasingly influencing sustainability reporting and assessment practices. 

A key driver of the double materiality approach is the European Financial Reporting Advisory Group (EFRAG), which requires companies reporting under the Corporate Sustainability Reporting Directive to conduct a double materiality assessment following its European Sustainability Reporting Standards (ESRS) guidelines. These guidelines aim to help companies assess and report on material ESG topics comprehensively. 

From a financial materiality perspective, investors focus on how ESG factors can impact a company’s financial condition and operational performance. For example, a company’s carbon footprint might have financial implications due to regulatory compliance costs, fines, or shifts in consumer preferences towards sustainable products. 

On the other hand, impact materiality evaluates how a company’s activities affect the environment and society, including contributions to climate change, engagement with local communities, and governance practices. This broader perspective acknowledges the vital role companies play in addressing global challenges such as climate change, social inequality, and corporate governance. 

By integrating both financial and impact materiality, this approach enhances the relevance and comprehensiveness of ESG ratings. Consequently, ESG rating agencies are likely to adapt their methodologies to include double materiality assessments, resulting in more holistic and accurate evaluations of companies’ sustainability performance. 

The future of ESG ratings

The role of ESG ratings in investment decisions and corporate sustainability strategies is undeniable. As the financial landscape continues to evolve, with a growing emphasis on sustainability and ethical practices, ESG ratings will remain a key tool for investors and companies. They facilitate informed investment decisions and drive businesses towards more sustainable and responsible practices, ultimately contributing to a more sustainable and equitable global economy. 

 With the EU leading the way, further regulation of rating agencies and the standardisation of methodologies are anticipated in the coming years. As double materiality assessments are very likely going to be integrated into ESG ratings, playing a pivotal role in shaping investment strategies, businesses should proactively prepare by initiating robust double materiality assessments. 

To understand more, one of our specialists can talk you through your needs, request a call back here. or contact our Head of ESG and Sustainability, Joaska Mischke here.