ESG Ratings: How They Work and Why They Matter

You've seen the scores. MSCI rates a company AAA. Sustainalytics gives it a high-risk flag. A third agency rates it somewhere in between.

ESG ratings are supposed to help investors navigate sustainability performance. But understanding how they work — and their limitations — is just as important as reading them.

What are ESG Ratings?

ESG ratings are assessments of a company's performance on environmental, social, and governance criteria, produced by specialist rating agencies.

They serve multiple purposes:

• Help investors identify ESG risks and opportunities
• Enable benchmarking across companies and sectors
• Inform index construction for ESG funds and ETFs
• Signal corporate ESG credibility to stakeholders

Major ESG Rating Agencies

MSCI ESG Ratings: The most widely used by institutional investors. Rates companies from AAA (leader) to CCC (laggard) based on industry-specific ESG risks.

Sustainalytics: Focuses on ESG risk exposure and management. Lower scores indicate lower unmanaged ESG risk.

S&P Global ESG Scores: Integrated into the Dow Jones Sustainability Index family. Based on detailed corporate sustainability assessments.

ISS ESG: Used heavily for governance assessment and proxy voting recommendations.

CDP: Focuses specifically on environmental disclosure — climate, water, and forests.

How ESG Ratings are Constructed

Despite differences in methodology, most ESG ratings follow a similar process:

Data collection: Companies disclose ESG data through sustainability reports, regulatory filings, and direct questionnaires. Agencies also use third-party data sources and news analysis.

Materiality assessment: Different ESG issues matter differently by industry. Carbon emissions are highly material for energy companies but less so for software firms.

Scoring: Weighted scores across E, S, and G dimensions are aggregated into an overall rating.

Review: Ratings are updated periodically — typically annually — with continuous monitoring for significant ESG events.

The Problem with ESG Ratings

Here's the uncomfortable truth: ESG ratings from different agencies frequently disagree — significantly.

A widely-cited MIT Sloan study examining six major rating agencies found average pairwise correlations ranging from roughly 0.4 to 0.7, with an average around 0.6. For comparison, credit ratings from agencies like Moody's and S&P correlate at about 0.99. In other words, ESG ratings disagree far more than traditional credit ratings ever do.

The same research traced the divergence to three sources: differences in measurement (the largest factor, accounting for over half the divergence), differences in scope (which factors are even included), and differences in weighting (how much each factor counts toward the final score).

Why the divergence?

• Different scope: Agencies measure different ESG factors
• Different weights: The same factor may be weighted very differently
• Different data sources: Some rely on disclosure, others on estimation models
• Measurement vs. management: Some agencies rate what companies do, others rate how they manage ESG risks

This divergence matters. An investor relying on a single ESG rating may be getting a partial — or misleading — picture.

How to Use ESG Ratings Intelligently

• Use multiple ratings: Cross-reference MSCI, Sustainalytics, and CDP for a more complete picture
• Understand methodology: Know what each agency measures and how
• Look beyond the score: Read underlying data and company disclosures directly
• Watch for rating changes: Upgrades and downgrades often signal meaningful ESG developments
• Consider sector context: Compare companies within the same industry, not across sectors

The Future of ESG Ratings

Regulatory pressure is pushing toward greater standardization. The ISSB's global baseline standards and the EU's ESRS are creating common disclosure frameworks that should improve rating consistency over time.

The Bottom Line

ESG ratings are tools, not verdicts. They provide valuable signals — but require critical interpretation.

The best ESG investors don't outsource their judgment to a rating agency. They use ratings as a starting point for deeper analysis. In a world where ESG data is still maturing, informed skepticism is a competitive advantage.

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Source: Berg, F., Kölbel, J.F., and Rigobon, R. (2022). "Aggregate Confusion: The Divergence of ESG Ratings." Review of Finance, 26(6), 1315–1344.

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