What is ESG Ratings?

What is ESG Ratings?

ESG ratings are assessments produced by specialized rating agencies—MSCI, Sustainalytics (Morningstar), S&P Global, ISS, and others—that evaluate a company's exposure to environmental, social, and governance risks and the quality of its management response. Unlike credit ratings, which converge around a common methodology, ESG ratings vary significantly across providers in methodology, scope, data sources, and output. MSCI uses a letter scale (AAA to CCC), Sustainalytics uses a numerical risk score, and S&P Global produces percentile rankings. These ratings influence index inclusion, investment screening, capital allocation, and increasingly, lending decisions.

Why It Matters

ESG ratings directly affect capital flows. Over $18 trillion in assets are benchmarked to ESG-screened indices, and a rating downgrade can trigger automatic exclusion from ESG funds. MSCI's ESG indices alone are tracked by $500+ billion in ETF and index fund assets. When a company drops from an "A" to "BBB" rating, it can lose access to a meaningful portion of its investor base, increasing capital costs and reducing share price support from passive ESG flows.

The divergence problem is well-documented and consequential. A landmark MIT study found that the correlation between major ESG rating providers is only 0.54, compared to 0.99 for credit ratings. Tesla, for example, has simultaneously held a top-decile rating from one provider and a bottom-decile rating from another. This divergence creates confusion for companies trying to manage their ratings, for investors trying to integrate ESG factors, and for regulators trying to prevent greenwashing.

Regulatory intervention is reshaping the ratings landscape. The EU adopted a regulation on ESG rating providers in 2024, requiring transparency about methodologies, conflict of interest management, and ESMA supervision. India's SEBI mandated ESG rating disclosures. These regulations aim to improve reliability and reduce the information asymmetry that currently characterizes the market. Companies should expect greater standardization—and therefore greater rating stability—as regulation matures.

Despite their limitations, ESG ratings function as a de facto accountability mechanism. Board members and executives increasingly face compensation tied to ESG rating improvements. Lenders incorporate ESG scores into credit risk models. M&A due diligence routinely includes ESG rating analysis. Ignoring ratings—or dismissing their methodology—doesn't make the capital market consequences disappear.

How It Works / Key Components

ESG rating methodologies generally follow three steps: identify material ESG issues for the company's industry, assess exposure to those issues, and evaluate management quality and track record. MSCI's methodology weights environmental, social, and governance pillars differently by industry—mining companies face heavy environmental weighting, while financial services companies see governance weighted more heavily.

Data inputs come from company disclosures (sustainability reports, annual filings, CDP responses), regulatory databases (EPA emissions data, OSHA violations), news and controversy monitoring, and direct company engagement (surveys and interviews). The balance between disclosed data and estimated data varies—Sustainalytics estimates roughly 40–60% of data points for companies that don't disclose comprehensively. This estimation introduces noise and is a key driver of rating divergence.

Rating agencies differ in what they're actually measuring. MSCI focuses on financially material ESG risks relative to industry peers—a "best in class" approach where an oil company can earn an "AA" by managing its ESG risks better than peers, regardless of absolute environmental impact. Sustainalytics measures unmanaged ESG risk exposure in absolute terms. S&P Global assesses both ESG performance and momentum. This methodological divergence means companies must understand what each rating actually represents rather than treating all ratings as interchangeable.

Companies can actively manage their ratings through three levers: improving actual ESG performance (the substantive lever), improving disclosure quality and completeness (the transparency lever), and engaging directly with rating agencies to correct data errors and provide context (the communication lever). Research suggests that disclosure improvements alone can shift ratings by one to two notches, as many rating penalties stem from missing data rather than poor performance.

Council Fire's Approach

Council Fire helps clients navigate the ESG ratings landscape by analyzing current ratings across providers, identifying the specific data gaps and performance issues driving scores, and developing targeted improvement strategies. We focus on substantive improvements that simultaneously enhance ratings and reduce actual risk, rather than superficial disclosure optimization—ensuring clients build durable ESG credibility with investors and rating agencies.

Frequently Asked Questions

Why do different ESG rating agencies give my company different scores?

Three sources of divergence drive rating discrepancies: scope (which ESG issues each agency considers), measurement (what metrics and data sources they use), and weighting (how they combine scores across issues). A company might score well on environmental metrics with one agency that uses self-reported data but poorly with another that relies on third-party monitoring data. Industry classification differences also matter—if agencies categorize your company in different peer groups, the benchmarks change entirely. Understanding each agency's specific methodology is essential for interpreting and managing your ratings.

How much do ESG ratings actually affect cost of capital?

Empirical evidence is growing. MSCI research shows that companies with improving ESG ratings experienced 10–20% lower cost of equity capital compared to those with declining ratings. Bank of America found that ESG rating improvements correlated with 2x lower earnings volatility. On the debt side, sustainability-linked loans increasingly reference ESG rating thresholds, with margin adjustments of 5–15 basis points tied to rating improvements. The effect is strongest for companies moving between rating tiers (e.g., from BB to A) and in sectors where ESG factors are most financially material.

Should my company focus on improving one specific ESG rating?

Focus on the ratings that matter most to your investor base and capital structure. If your top 10 institutional shareholders use MSCI data, prioritize understanding MSCI's methodology. If you're issuing sustainability-linked bonds referencing Sustainalytics, focus there. However, improving underlying ESG performance and disclosure quality tends to lift all ratings simultaneously. The most efficient approach is identifying cross-cutting gaps—such as missing climate disclosure or absent board diversity policies—that negatively affect ratings across multiple providers, then addressing those first.