This post provides a brief guide on how ESG criteria and ESG scoring work plus the challenges in determining ESG performance; for an overview of ESG-focused investing, check out a previous post, titled, What is ESG Investing.

Companies with ESG practices are scored on environmental, social, and governance responsibility scales. These scores are determined by an internal company framework, third-party companies, research groups, and data providers.

ESG Criteria: Environment, Social, and Governance

The ESG criteria provide a framework that asset managers and investors use to identify companies with good social and environmental values so that they can add these companies into their investment portfolios.

The three  ESG criteria–Environmental, Sustainability, and Governance–provide a well-rounded perspective about a company’s long-term potential and performance. They can tell if a company is providing a positive impact to society and the environment by how the company treats their shareholders, if they are making their products with sustainable materials, how they are addressing issues like climate change, gender pay gap, diversity and inclusion, and more.

Environment

A company’s impact on nature and the environment and its ability to contribute positively to the environment while mitigating risks that could harm it. This can include a company’s carbon footprint, energy efficiency, conservation of water and other natural resources, treatment of animals, and waste management.

It can also include whether the company uses toxic chemicals in its manufacturing processes and supply chain. Research has shown that companies that practice sustainability and go green can actually reduce operational costs. For example. according to a study by Energysage, commercial properties can reduce their electricity bill by 75 percent by installing solar panels.

Social

A company’s impact on society within its organization and broader community resonates with large groups of people. There are various causes that make up social impact, but they all seek to improve the quality of life. Social factors include LGBTQ+ equality, racial diversity in the staff and within the executive suite, inclusion programs, hiring practices, company culture, and even how a company treats its customers, suppliers, employees, and the local community. Additionally, it looks at how a company promotes and supports social good beyond its sphere of business.

Since there are no laws forcing companies to disclose social impact performance, how can investors interested in ESG find out whether a company is really socially responsible?

  • The Global Reporting Initiative (GRI) and Principles for Responsible Investment (PRI) provide a respected framework to evaluate whether companies have strong social mandates. ESG investors often look to sustainability reports by the GRI and PRI as both go beyond how a company addresses environmental issues to include information related to employees, suppliers, and the community.
  • Media reports on companies’ lobbying efforts related to social justice issues as well as how companies treat their employees are also relevant.
  • Sites like Glassdoor provide first-hand insight into how a company and its management is viewed by its potential, current, and former employees.

A few things to look for to determine a company’s social standings include:

    • Employee turnover/churn and employee engagement
    • Past performance on consumer protection such as lawsuits, product recalls, and regulatory penalties
    • Employee training and development
    • Friendly and responsive customer service
    • Diversity and inclusion in hiring and in promotions
    • Ethical supply chain sourcing
    • Public stance on social justice issue

Governance

Governance is basically how a company is managed by top executives and board of directors, including how they respond to the interests of the company’s various stakeholders.

Some of the governance factors under consideration include:

  • Executive compensation is a primary focus- whether executives favor multi-million-dollar bonuses while imposing a salary freeze in effect for other employees, etc.
  • The company is backed by a strong board of directors that relates well to various stakeholders; there is no conflict of interest for board members; and the company’s chairman and CEO roles are separate.
  • Transparency with shareholders and relationship between shareholders
  • The IT department runs its business effectively and the management aligns team incentives with the company’s success.
  • The company provices honest financial reporting  and accounting transparency, avoiding conflicts of interests, diverse board members and executives, and an inclusive work culture.
  • A good working relationship with U.S. Securities and Exchange Commission (SEC) and other regulatory bodies.

Details can be found in sustainability reports by the GRI and PRI, but investors should also read annual proxy statements from the companies in which they own shares.

Additionally, the SEC offers proxy statements, in which investors can search for filing type DEF 14S (definitive proxy statement), which is required under Section 14(a) of the Securities Exchange Act of 1934. This statements helps shareholders understand corporate governance practices.

ESG Scoring

Asset managers, institutional investors, financial firms, and other stakeholders are increasingly interested in ESG scoring reports that measure and evaluate a company’s ESG performance over time and in relation to their peers.

ESG scores normally follow a 100-point scale and a company is assessed based on which quartile it falls into relative to a peer group. For example, Refinitiv, a leading ESG research company and data provider divides it scores into four quartiles, as shown in the image below.

ESG_Score_2

Source: Refinitiv

A few of the most well-regarded ESG research companies include S&P, Sustainalytics, MSCI, Refinitiv, and Bloomberg. While each firm that rates ESG assesses specific factors unique to the company and industry it is rating, they commonly review data from corporate sustainability measures, annual reports, resource management, employee engagement, financial management, board structure, executive compensation, supply chain issues, waste management, controversial weapons screenings, and more.

The various data sources that research firms must extract insights from can be time consuming as data can come in the form of structured and unstructured text. Therefore, there are several obstacles that ESG research firms face in obtaining accurate and real-time ESG scores to assess a company’s ESG performance.

Challenges in Determining ESG Performance

With the rise in unstructured data projected to grow at 55-65 percent each year, analysts and investors continue to face challenges in researching large sets of data sets and extracting relevant information to obtain accurate ESG insights.

The key challenges in calculating accurate ESG scores are discussed below.

Lack of Real-Time Data

Data is constantly generated with every company tweet, news headline, announcement, and even reviews from stakeholders. The frequency of data generated often makes it hard for investors and analysts to keep up with the latest news on a company’s ESG practices.

Lack of Transparency

Two decades ago when the Global Reporting Initiative launched its ESG guidelines, only a handful of companies disclosed their environmental performance. Although the world’s largest corporations by revenue are leading the way in reporting ESG data, there are still many companies that have not detailed ESG practices in formal filings. This lack of transparency makes it difficult to calculate accurate ESG scores.

Risk of Missing Critical Details

With the volume of data and the speed at which new data is constantly generated, important details critical to investment decisions can be missed.

Limited Coverage of ESG Factors

There are several ESG factors that are listed under each environment, social, and governance criteria. A well-rounded view on a company’s ESG practices includes multiple ESG factors and take into account recent events around a company’s ESG impact.

Using AI/ML/NLP for Driving ESG Insights

Analysts can use AI and NLP, at scale, to gather useful, hidden, and timely information on sustainability, diversity, inclusion and  ethical practices for companies in their portfolios or discover new investment opportunities. AI can also help analyze the data pulled by attaching a sentiment score to the content, so that analysts know what to do with the information.

The components of a strong NLP model include content, taxonomy, and analytics.

Content

A large volume and diverse set of global content such as news, corporate filings, transcripts, investor reports, press releases, trade journals, social media posts, and the like must be analyzed to get a well-rounded view on a company’s ESG practices.

Taxonomy

A variety of taxonomies to apply to the NLP model provides analysts with more options and a broader range of content to cover. Taxonomies include companies and ESG events/factors. For example, a taxonomy could be the company Apple and/or the ESG event diversity.

Analytics

Analytics can tie back identified topics to specific companies and identify sentiment and quantify the relevance and impact. Analytics include entity and event extraction, sentiment analysis on the information, document classification, and relevance analysis.

Accern NoCodeNLP Platform for ESG Insights

The Accern NoCodeNLP Platform empowers citizen data scientists, such as research and financial analysts as well as data scientists to use AI without having to code.

Using the pre-assembled data sources – global news and public data and content from leading data providers including FactSet, Morningstar, Dow Jones, Naviga, and more – users can build ESG focused NLP models with historical and real-time information.

With data on thousands of public and private companies and over 26 ESG events that come out-of-box including but not limited to fuel management, supply chain, employee health, safety, and wellbeing, labor relations, social impact, and business ethics, investors and financial firms can identify a company’s ESG practices by calculating accurate ESG scores.

Schedule a demo to learn more about the Accern NoCodeNLP Platform and how it can drive ESG-focused insights for your investment portfolio.