What it means
Rating agencies build these grades much as credit rating agencies build credit ratings, by scoring a set of underlying indicators and rolling them into one summary judgement. The environmental pillar covers matters such as emissions and resource use, the social pillar covers employees, customers and communities, and the governance pillar covers board structure, pay and shareholder rights.
The final grade reflects how those three pillars are weighted for that particular industry. Ratings matter commercially because they are used as gatekeepers.
Index providers use them to decide which companies enter sustainable indices, lenders use them in sustainability linked loan pricing, and large customers increasingly use them in supplier selection, so a downgrade can have very real cash consequences. An important nuance is that most ratings are industry relative rather than absolute.
An oil company can hold a strong ESG rating because it manages its risks better than its peers, which frequently surprises people who assume the rating measures environmental impact in absolute terms. Ratings from different providers frequently disagree, sometimes dramatically.
This happens because agencies choose different indicators, weight the three pillars differently and treat missing disclosure differently, with some assuming the worst and others simply excluding the item. For a company on the receiving end, the practical response is to find out which agency its key investors and customers actually use, read that agency's methodology, and check what data it holds.
A surprising share of poor ratings come from unanswered questionnaires and missing public disclosure rather than from genuinely poor performance.
In practice
Real-world examples.
Example
A listed retailer is downgraded by one rating agency after a supply chain labour investigation. Two large index funds are required by their mandates to reduce the holding, and the share price falls before the company has issued any financial update.
Example
A food producer discovers its low environmental rating stems entirely from never having published water usage data. It adds three metrics to its annual report, and the rating improves at the next review without any change to actual operations.
Example
A construction group negotiating a sustainability linked loan agrees a margin that falls by 0.10% if its ESG rating reaches a stated band within two years. On $50,000,000 of drawn debt that is worth $50,000 of annual interest, which funds the reporting improvements needed to get there.
Think of it
“ESG rating grades your sustainability performance-a letter or number from rating agencies.
Formula
Calculation
Overall ESG rating score = (Environmental pillar score x environmental weight) + (Social pillar score x social weight) + (Governance pillar score x governance weight), with the result mapped to a rating band
An agency rates a mid sized chemicals manufacturer. Because the industry is emissions intensive, the agency weights the environmental pillar at 40% and the social and governance pillars at 30% each. The company scores 62 on environmental, 71 on social and 85 on governance, each out of 100.
Environmental contribution = 0.40 x 62 = 24.8. Social contribution = 0.30 x 71 = 21.3. Governance contribution = 0.30 x 85 = 25.5.
Overall score = 24.8 + 21.3 + 25.5 = 71.6 out of 100.
Under this agency's published bands, 70.0 to 79.9 maps to an A rating, so the company is rated A. Note how sensitive the outcome is to weighting: if the environmental pillar were weighted at 60% and the other two at 20% each, the score would be (0.60 x 62) + (0.20 x 71) + (0.20 x 85) = 37.2 + 14.2 + 17 = 68.4, dropping the company into the band below.Case study
Seen in the real world.
The following is an illustrative and clearly fictional example. Ravensworth Components, an invented automotive parts supplier, was told by its largest customer that suppliers rated below a certain ESG band would be dropped from the approved list within eighteen months. Ravensworth was rated in the bottom band by the agency its customer used and had no idea why.
The finance director requested the underlying data and found that more than half the lost points came from indicators the agency had marked as undisclosed, including energy consumption, board diversity and a written anti bribery policy. The company had all three; it had simply never published any of them.
Over nine months the fictional company published the missing disclosures, formalised two policies that had previously been informal practice, and responded to the agency's questionnaire for the first time. Its rating moved up two bands, it kept the contract, and the finance director's summary to the board was blunt: most of the improvement was disclosure, and the genuine operational work still lay ahead.
Watch out
Common mistakes.
- Reading an ESG rating as a measure of absolute environmental impact, when most ratings compare a company only against others in the same industry.
- Assuming ESG ratings are audited or regulated in the same way as financial statements, when they are opinions produced from largely self reported data.
- Chasing a rating improvement through disclosure alone and then treating the underlying risks as resolved.
Questions
People also ask.
Why do agencies give the same company different ratings?
Because they choose different indicators, apply different pillar weights and handle missing data differently, so divergence is built into the system rather than being a sign that one agency is wrong.
Can a company challenge its ESG rating?
Most agencies allow companies to review and correct the underlying data, which is worth doing because factual errors and undisclosed items are a common cause of weak grades.
Do private companies get ESG ratings?
Less commonly, though private firms are increasingly assessed through customer and lender questionnaires that work in much the same way.
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