The consideration of Environmental, Social, and Governance (ESG) factors has become increasingly vital to making informed investment decisions. Investors want to understand at a detailed level the most material ESG issues, as well as an investment’s risk exposure. With ESG-related risks often being multi-faceted, numerous, and varying across sectors and geographies, this analysis can be complex. To aid investors and stakeholders ESG risk ratings have become a widely adopted method to simplify the process and enable comparisons between investments easier to digest.
According to ERM, harnessing ESG risk ratings can help companies to avoid litigation risk, by avoiding greenwashing in their ESG disclosures, helping enhance brand value and stakeholder trust. Better ESG risk management is clearly linked with higher ESG ratings, creating a virtuous circle of improvement. For an analyst to generate a higher ESG rating, they require disclosures that show how a company manages risk effectively. While rating providers will utilise many sources such as news pieces, industry publications, and even AI tools, the most cost-effective way to ensure great ratings is through the creation of a detailed sustainability report. This report should align with one or several recognised reporting frameworks, such as SASB, or GRI, and must be informed by a comprehensive materiality assessment. In fact, in the UAE, listed public joint stock companies on the Abu Dhabi Securities Exchange and Dubai Financial Market (DFM) are now obliged to publish a sustainability report annually, outlining their long-term strategy and impact on ESG and the wider economy.
According to the Berkley Business Law Journal, an ESG risk is considered to be material, (and should be rated), if it’s inclusion or absence in financial reporting is likely to influence the decisions made by a ‘reasonable’ investor. The Journal makes it clear however that the idea of a ‘reasonable investor’, can be a challenging concept in practice, which is why it’s even crucial that investors and companies use the right risk rating framework that best aligns with their needs.
Below are just a few of the ESG risk ratings frameworks available globally:
Fundamentally, ratings assess and quantify how much of a company or investment’s economic value is at risk due to ESG factors, usually with reference to a peer-to-peer comparison. This is achieved by evaluating the exposure and management of material ESG issues. Usually, a total of unmanaged risks is quantified, and then combined into a single score to quantify the entities overall ESG risk. With the rise of the double-materiality principle as a cornerstone of ESG assessments, most ESG ratings will also consider the risk exposure that a company creates for external stakeholders. As Paul Polman, former CEO of Unilever stated: ‘Sustainability is no longer about doing less harm. It’s about doing more good’.
Before choosing an ESG ratings framework, it’s important to understand the difference between a credit rating and an ESG rating. Credit ratings are generated by credit rating agencies (CRAs) and assess the credit risk of an issuer of debt instruments or of a specific issue. ESG ratings, however, are typically produced by ESG data providers and are non-credit products. They are synthetic indicators of the ESG characteristics or exposure to ESG risks of an issuer of equity or debt instruments. There are credit ratings that include ‘ESG Indicators’ such as Fitch Ratings ‘ESG Relevance Scores’, and S&P’s ‘ESG Credit Indicators’, among others. The Principles for Responsible Investment (PRI), which cites over 30 ESG ratings frameworks in its recent guide, have recently launched ‘The ESG in Credit Risk and Ratings Initiative’, aiming to enhance the transparent and systematic integration of ESG factors in credit risk analysis. The link between Credit rating and ESG ratings continues to evolve, especially with the rise of ESG linked finance, which we will be discussing in our next article ‘Navigating ESG ratings challenges, opportunities and regional progress’.
As an example of the ESG issues considered in ESG focused credit ratings, the ‘financially material’ ESG topics for Fitch ‘ESG Relevance Score’ include:
With a myriad of risk ratings frameworks out there, it can be tough to know which one is the right one to assess your security, fund, or portfolio. For instance, Sustainalytics uses an absolute approach to highlighting risk, while MSCI uses a sector-relative scoring approach. According to Sustainalytics, when rating ESG risk it uses four categories. These are: ESG ratings (credit focussed), third-party certifications, ESG disclosure metrics, and industry focussed ratings.
Ratings such as those offered by Sustainalytics can be used alone or together with others, to assess the following categories of risk: Material ESG issues, systemic issues, idiosyncratic issues (e.g. sector-specific risks), corporate governance, and stakeholder governance. Ratings frameworks will consider the severity of risk exposure for a given risk, (from negligible through to severe), and whether a risk is growing over time, static or receding. Related to this is understanding what risks are ‘manageable’ (within the company’s control), which are ‘unmanageable’, (out of the company’s control), which are ‘managed’ currently, and risks that are ‘unmanaged’, Unmanaged risks may be unmanageable, or simply unaddressed by the company at present (i.e. risk responses that can be improved. Once all these nuances have been incorporated, a rating between AAA (ESG Leader) and CCC (ESG Laggard) is generated. Most companies will fall somewhere on the bell curve between these extremes.
In the Middle East, the most popular ESG rating providers are also the most popular globally. These are CDP, MSCI, Sustainalytics, Refinitiv, S&P Global, and ISS ESG. Another leading player particularly in the Middle East is Fitch Ratings. Fitch Ratings offers specific guidance to the DFM on how ESG factors affect the issuance of credit ratings. For instance, in 2024 ‘Fitch Solutions’ announced its ‘ESG Ratings for Banking in the Middle East & Turkiye’. Specific ratings frameworks commonly used to rate ESG performance in the region include the ‘MSCI Europe and Middle East ESG Leaders Index’, as well as ‘The S&P/Hawkamah ESG Pan Arab Index’.
From the myriad of ESG ratings providers, to the numerous rating methodologies, the rating of ESG factors in investments is both a complex and compelling opportunity for investors and ESG leaders. In our next article, we will explore many benefits of harnessing ESG ratings, as well as the regional challenges to their adoption in the Middle East.
