Head of ESG investments, Saxo Bank.
Summary: Environmental, Social and Governance (ESG) risks refer to the potential negative impact a company can have on the environment and society. Companies’ ESG risk ratings can help you reduce risk and enhance long-term performance, but do you know how to interpret such ratings? Check out the article below to get a better understanding of how to read an ESG risk rating.
In addition to the ESG risk score, there are 3 individual scores: an Environmental score, a Social score and a Governance score. The ESG risk score (the “score”) is made up of the 3 ESG pillars and is the sum of the individual Environmental, Social and Governance scores. The score which focuses on ESG risk, ranges from 0 to 100. The lower the score the better as this indicates low risk. A score of 0 is equivalent to no risk, while a score of 100 indicates severe risk. In the example below, Tesla's ESG risk score is 25 and the E, S and G scores are 3.3, 14.1 and 7.8 respectively. Tesla falls in the medium risk category.
The Environmental score, the Social score and the Governance score measure the degree to which a company's value may be at risk driven by ESG factors.
Environmental factors include carbon footprint, use of natural resources, pollution and management of waste
Social factors are associated with workers’ safety and well-being, diversity, equity and inclusion, supply chain management and community engagement
Governance factors cover ethics and transparency, corporate practices (accounting, risk and audit), executive remuneration and the board of directors’ composition and quality.
The risk categories are absolute as they reflect the level of unmanaged ESG risk a company is exposed to. This means that companies from different sectors can be compared based on their category.
A company will have a good ESG risk rating score either because it is well-governed and manages its ESG risks well or because it is involved in activities that have low exposure to ESG risks.
Which one is better? a company with a score of 25 or one with a score of 30? Based on Sustainalytics’ methodology, the company with the lower score is better than the company with the higher score, in terms of ESG risk. Looking at the scores below, Tesla, which has a score of 25 and is in the medium risk category, ranks better than Amazon which has a score of 30 and falls within the high risk category.
It is worth noting however, that there are nuances to ESG risk scores. Investors who care about particular ESG factors should take a closer look at the individual components of the scores, namely the E, the S and G scores. For example, though Tesla and Alphabet have almost identical scores, 25 and 24 respectively, there are differences when it comes to their respective Environmental and Governance scores. Surprisingly, Alphabet’s E score is better than Tesla’s. Though Tesla’s contribution to a greener world is unrivalled, Alphabet has made significant strides over the years, achieving carbon neutrality in 2007 and matching 100% of its global electricity usage with renewable energy since 2017.
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