ESG Scoring: How Companies Get Graded on ESG

Key Takeaways

• ESG scores are composite ratings produced by data vendors that summarise a company's environmental, social, and governance risk management relative to peers or on an absolute basis.
• MIT research found pairwise correlation of only 0.54 across major ESG raters, versus roughly 0.99 for credit ratings, driven mainly by measurement and scope differences.
• A common investor mistake is treating a single ESG score as an objective truth rather than a summary of dozens of subjective choices made by one vendor.
• ESG scores are primarily a risk-management tool used to screen portfolios and build indexes, not a direct measure of ethical performance.

What It Is

An ESG score is a composite rating produced by a data vendor (MSCI, Sustainalytics, S&P Global, ISS, Refinitiv, FTSE Russell, and others) that summarises how a company performs on three pillars. Environmental covers emissions, resource use, and climate exposure. Social covers labour, human rights, product safety, and community impact. Governance covers board structure, executive pay, audit quality, and shareholder rights.

Vendors score each pillar from underlying indicators, then blend pillar scores with industry-specific weights. The output can be a letter grade (MSCI runs AAA to CCC), a risk score (Sustainalytics runs 0 to 100, lower is better), or a percentile rank. The rating is then used by ESG funds, index providers, and regulators as a shorthand for sustainability.

The Intuition

Investors wanted a single metric that combined climate, labour, and governance risk in the same way a credit rating combines balance-sheet and business risk. ESG scores try to be that metric. The idea is that companies with weak governance or unmanaged environmental risk face higher long-run costs, litigation, and regulatory exposure, and a score surfaces that risk before it hits earnings.

The catch: unlike credit, there is no default event to calibrate against. Agencies define ESG differently, weight pillars differently, and pick different indicators. That freedom is why ESG scores diverge sharply across vendors.

How It Works

A typical scoring pipeline has four steps:

1. Data collection. Vendors pull company disclosures (sustainability reports, 10-Ks, proxies), regulatory filings, NGO and media reports, and survey responses. Data quality is uneven, especially for smaller firms.
2. Indicator scoring. Each pillar has dozens of sub-indicators (Scope 1 emissions, injury rates, board independence, pay ratios). Each indicator is scored on a scale.
3. Materiality weighting. Indicators are weighted by how financially material they are for the company's industry. An oil major gets heavy weight on emissions and spills. A bank gets heavy weight on data privacy and governance. The SASB framework (now part of ISSB) is the common reference for what is material by industry.
4. Aggregation. Pillar scores are combined into one overall score, sometimes with adjustments for controversies (a recent scandal drags the rating down).

The exact formula is proprietary and differs by vendor. That is the central problem.

Worked Example

Suppose a hypothetical consumer-goods company gets the following pillar scores on a 0 to 10 scale from one vendor: E = 6, S = 7, G = 8. With industry weights of 40% environmental, 30% social, 30% governance, the overall score is:

overall = 0.40 * 6 + 0.30 * 7 + 0.30 * 8 = 2.4 + 2.1 + 2.4 = 6.9

A different vendor looks at the same firm and scores E = 4 (they weight supply-chain emissions heavier and count a recent controversy), S = 8, G = 7, with weights of 50 / 25 / 25. The second vendor's score:

overall = 0.50 * 4 + 0.25 * 8 + 0.25 * 7 = 2.0 + 2.0 + 1.75 = 5.75

Same company, very different ratings. This is not a thought experiment. Berg, Koelbel, and Rigobon (MIT, 2022) studied six major raters and found an average pairwise correlation of only 0.54 across ESG ratings, compared to roughly 0.99 for credit ratings. They decomposed the divergence into three sources: measurement (56%), scope (38%), and weight (6%). The paper called the result "aggregate confusion."

Common Mistakes

1. Treating the ESG score as an absolute measure. A single letter or number compresses dozens of subjective choices into one headline. It is a summary, not a truth. Read the pillar breakdown and the materiality map before drawing conclusions.

2. Assuming ratings agree across providers. They do not. A company rated AAA by MSCI can be rated "Severe Risk" by Sustainalytics at the same time, because the two firms define ESG risk differently. Anyone building an ESG strategy on one vendor's score is making a data choice, not finding objective truth.

3. Ignoring materiality differences. MSCI and Sustainalytics use industry-relative materiality, so a tobacco firm with clean governance can score well. Absolute frameworks penalise the sector outright. Know which logic the score uses before you filter on it.

4. Conflating ESG investing with ethical investing. ESG scoring is primarily a risk-management tool that flags unmanaged environmental, social, and governance exposures. Ethical investing (exclude weapons, tobacco, adult content) is a values-based screen. High ESG scores do not mean a company is "doing good," only that its material ESG risks are managed relative to peers.

5. Treating the "E" weight as universal. Pillar weights are industry-specific. A software firm's rating is dominated by governance and data privacy, not carbon. Assuming every ESG score is a climate score confuses readers and leads to flawed portfolio construction.

Frequently Asked Questions

Q: What is ESG scoring in simple terms? ESG scoring is a vendor's grade for how well a company manages its environmental (carbon, resource use), social (labour, human rights), and governance (board structure, pay) risks. It compresses many data points into a single number or letter rating so investors can compare companies quickly.

Q: How does ESG scoring affect investment decisions? Asset managers use ESG scores to screen out low-rated companies, build sustainability-focused indexes, and meet regulatory requirements under frameworks like SFDR. A low score can reduce a company's access to ESG-labelled capital, though the link to financial performance is still debated.

Q: What is a real-world example of ESG scoring divergence? The MIT Aggregate Confusion Project found that the same company could receive an MSCI AAA rating and a Sustainalytics "Severe Risk" score simultaneously, because the two firms define and weight ESG risk differently. This is not an edge case, it reflects the structural absence of agreed definitions.

Q: How can investors use ESG scores without being misled? Investors should read the pillar-level breakdown and the materiality map behind any score, use more than one vendor to cross-check, and understand whether the score is industry-relative (MSCI) or absolute (Sustainalytics) before drawing conclusions.

Q: How is ESG scoring different from credit rating? Credit ratings can be back-tested against default events, which forces calibration toward a common scale. There is no equivalent default event for ESG, so each vendor builds its own definitions, indicators, and weights, which is why ESG scores diverge far more than credit ratings do.

Sources

1. MSCI ESG Research. "ESG Ratings Methodology." https://www.msci.com/documents/1296102/34424357/MSCI+ESG+Ratings+Methodology.pdf
2. Morningstar Sustainalytics. "ESG Risk Ratings Methodology Abstract, Version 3.1." June 2024. https://www.sustainalytics.com/docs/knowledgehublibraries/default-document-library/sustainalytics_-esg-risk-ratings_-version-3-1_-methodology-abstract_-june-2024.pdf
3. Berg, F., Koelbel, J.F., Rigobon, R. (2022). "Aggregate Confusion: The Divergence of ESG Ratings." Review of Finance, 26(6), 1315-1344. https://academic.oup.com/rof/article/26/6/1315/6590670
4. MIT Sloan Sustainability Initiative. "The Aggregate Confusion Project." https://mitsloan.mit.edu/sustainability-initiative/aggregate-confusion-project

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.