From Core to Score: A layered look into ESG fund ratings

In the world of finance, sustainability ratings (including environmental, social and, governance (ESG)) are becoming increasingly influential in shaping investment decisions. Despite recent challenges encountered by ESG-oriented themes, ratings provide investors with insights into the sustainability risks and opportunities that a company is exposed to. A range of agencies in the market provide ratings on both a company and fund level, including (but not limited to) many well-known market data firms such as Moody’s, MSCI, S&P, and Sustainalytics.

The fund rating process is a layered approach where the individual company ratings feed into the overall rating for an investment fund. In this article, we will look at the rating process used by one data provider, MSCI, which illustrates how investors can get a better picture of how their portfolio is exposed to ESG risks and opportunities.

Company ratings

The process begins with an in-depth company evaluation based on 35 distinct ESG issues that differ by sector. Taking Apple Inc as an illustrative example, MSCI assesses its performance across material ESG factors such as: climate change mitigation strategies, labour management practices, corporate governance policies, and overall ethical conduct. The materiality of each factor depends on the sector and the peer group, further detail on this to follow.

Figure 1: Sustainable investing & MSCI ESG ratings

Source: MSCI

Continuing with the example, Apple’s rating is heavily influenced by social factors including - human capital development and privacy and data security and governance factors, which include corporate governance  corporate behaviour, given the nature of its operations. The identification of these material issues aids in identifying exposure to ESG risks and the subsequent rating gauged aids in risk management. For example, the risks and opportunities facing a mining company would be very different from those facing Apple - which is in technology hardware, storage and peripherals. The approaches to assessing risks and opportunities is very much industry and company specific.

Figure 2: MSCI Apple ESG ratings report

Source: MSCI

The evaluation of a company’s exposure to these material issues and its management of these issues, results in a numerical ESG scores on a scale of 0 to 10. This numerical ESG score is subsequently translated into letter ratings ranging from CCC (indicating substantial ESG risk and poor management) to AAA (indicating minimal risk and exemplary ESG management).

Figure 3: MSCI ESG ratings

Source: MSCI

Fund level ratings

The second stage involves the aggregation of these individual company ESG score at a fund level, adjusted by the weight each company holds within a portfolio, typically based on fund allocation/weight.

For instance, Apple’s substantial presence in investment funds, such as the Vanguard ESG US Stock ETF – means its ESG score significantly influences the overall ESG rating of the fund, depending on the market capitalisation weighting. MSCI mandates that at least 65% of a fund’s holdings by either market value or count must have valid ESG ratings to ensure that the aggregated fund rating reliably reflects its constituent companies’ ESG profile.

Subsequently, as mentioned earlier, MSCI organises funds into peer groups to facilitate accurate and equitable comparisons based on material issues and areas of focus. Continuing with the example, the Vanguard ESG US Stock ETF is benchmarked against similar US equity ESG funds. MSCI then calculates a weighted average ESG score for each fund, ranking it within its designated peer group. This comparative benchmarking enables investors to discern how well the fund performs relative to similar investment products.

Controversy assessments

Moreover, MSCI incorporates an additional layer of scrutiny by considering significant ESG controversies. If Apple, for example, faced substantial controversies related to labour practices or regulatory compliance, these issues would negatively affect its ESG score. Such incidents can also impact the ESG rating of the funds holding substantial positions in Apple, leading to a downward adjustment of the overall fund rating. Effective management of past issues, such as improvements in supply chain labour practices, often mitigates potential negative impacts, helping maintain a strong ESG profile.

Fossil fuel exposures

Additionally, MSCI assesses fossil fuel exposure within funds, influencing the ESG ratings based on the extent of such exposure, particularly within funds marketed with a sustainability or ESG-focused investment approach. Given Apple's minimal exposure to fossil fuels and its proactive stance on renewable energy use across its global operations, it generally enhances the ESG profile of funds in which it is heavily weighted.

The final ESG fund rating, updated monthly, comprehensively integrates the quality of underlying holdings, their proportional weightings, ESG controversy adjustments (that is the change in the rating points based on any recent controversy experienced by the company), and fossil fuel considerations. For example, the Vanguard ESG US Stock ETF currently maintains an A ESG rating, indicating strong ESG management and relatively low ESG risk exposure compared to peers.

Practically, MSCI's ESG ratings allow investors to align their investment portfolios with personal or institutional sustainability and ethical goals. Investors seeking to avoid industries like fossil fuels or support responsible corporate governance find these ratings instrumental in shaping their portfolio choices. Additionally, robust ESG ratings often correlate positively with long-term financial stability and resilience, as companies effectively managing ESG risks typically exhibit stronger operational adaptability and lower long-term exposure to reputational and regulatory risks.

In summary, ESG rating tools can provide investors with a systematic approach to evaluating sustainability performance at both company and fund levels. This evaluation process empowers investors to make well-informed, responsible investment decisions that can simultaneously achieve financial objectives and contribute positively to broader societal and environmental outcomes.

Figure 4: Summary of sample ESG rating process

Source: Davy