The ESG risk rating of your investments
Financial institutions that recognise the importance of sustainable investments can use the ESG risk rating to indicate how sustainable a company's operations are and therefore how sustainable it is to invest in that company. The abbreviation ESG stands for 'environmental, social and governance' criteria.
Environmental
What efforts is a company making, e.g. to reduce CO2 emissions, water use and waste? Does the company recycle? Does the company report on its own environmental impact?
Social
Does a company provide safe working conditions and good pay for its employees? For example, is there a policy against discrimination? How does the company deal with its suppliers? What does the company do to exclude child labour from the production process?
Governance
Is the company susceptible to corruption? How is the supervisory board composed? Does the company lobby the government? How transparent is the company about its policies and operations?
What is the ESG risk rating of your portfolio?
Your quarterly report will include an infographic as shown above, albeit likely with different figures.
- Item 1 shows several bars.
• The blue section shows the overall risk exposure. This is the total ESG risk to which all the companies in your portfolio are exposed.
• The grey section shows the controlled risk. That is the part of the risk that the companies in your portfolio can control.
• The green section shows the risk they cannot control. That is the ESG risk rating of the companies in your portfolio, so in the above case the ESG risk rating is 52 – 34 = 18. - Item 2 shows you the number 18 again in green with a grey number next to it, which is the benchmark. The ESG risk rating above is well below the benchmark, which is good.
- Item 3 is a bar showing the classification of your ESG risk. 18 is in the 'low' category. You can also see that the weighting of this classification rises quickly: from 40 onwards, the ESG rating is already 'very high'.
ESG research
Our partner Sustainalytics researches and assesses the ESG business performance of these companies based on the three ESG themes. Sustainalytics is a global leader in ESG research. Sustainalytics' research method consists of three building blocks.
Building block 1: Corporate Governance
The first building block is the basis of the research: corporate governance. This type of research is the same for every company: all companies are examined based on the same corporate governance factors, such as shareholder rights and the remuneration of the management.
Building block 2: Material ESG issues
The next building block consists of research into so-called 'material ESG issues'. They focus on the business processes, the sector and the location. Certain factors that may have a major impact are examined in that regard. These factors include:
- Access to basic services
- Bribery and corruption
- Business ethics
- Community relations
- Data privacy and security
- Emissions and waste
- Human rights
- Health and safety
For an oil company, for example, these factors will include 'emissions and waste', 'bribery and corruption' and 'health and safety', while for a software company the focus will be more on 'data privacy and security'.
Building block 3: Idiosyncratic ESG issues
The last building block involves research into idiosyncratic ESG issues. These are ESG issues that emerge in companies unexpectedly, and are known as 'black swans'. Of course, controversies may occur in relation to the aforementioned factors. If there is an oil leak at an oil company, the company will receive a higher 'emissions and waste' rating. This risk is a known problem, but what if an oil company suddenly has a 'data privacy and security' issue with its customer data? An unpredictable event of this kind is not expected in that sector, which is why it is called an idiosyncratic ESG issue.
The company will also receive a higher rating for this issue. Sustainalytics then examines whether this could also pose an unexpected risk to other companies within the same industry. The method then generates the ESG risk exposure. Sustainalytics subsequently examines how well these risks are managed. The ESG risk refers to risks that can't be properly controlled or which are not controlled properly. The lower the rating, the better.