New on FinoLib · Volume III: Finance Encyclopedia
I have just published a new article on FinoLib, my free finance education library: ESG Ratings Explained: How They Are Constructed. It is part of Volume III: Finance Encyclopedia. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
7.1 From Naming ESG to Understanding It
The idea in plain words
Company emissions are counted in three scopes under the GHG Protocol. Scope 1 comes from sources the company owns or controls. Scope 2 comes from the energy it buys. Scope 3 covers everything else in its value chain, from suppliers to customers’ use of the product. Scope 3 is usually the largest share and the least precise, so a carbon footprint is only as good as its Scope 3 method.
Key points
■Scope 2 has two methods: location-based (grid average) and market-based (contracts and certificates); report and read both.
■In the worked example, Scope 3 is 88.7% of a 186,010-ton footprint, and certificates cut market-based Scope 2 by 62% without changing a machine.
■Financed emissions attribute a borrower’s emissions to lenders by outstanding amount ÷ enterprise value including cash (PCAF).
A closer look
Volume I, Part 8: Operational Risk Governance & Reconciliation named ESG (Environmental, Social, Governance) as a set of factors investors weigh alongside financial metrics. This Part shows how that idea is put into practice: how emissions are counted (this section), how ratings are built from disclosures and why they disagree (Sections 7.2 and 7.3), how green and sustainability-linked debt is structured (Sections 7.4 and 7.5), how regulators police the claims, and why the whole field is now contested from two sides at once. Start with carbon, because almost every climate number you will meet in a rating, a fund report or a loan agreement is built from the same accounting.
Decision rule
Before you rely on any company’s carbon number, ask four questions. If the claim is about Scope 2, demand both the location-based and market-based figures; if they differ by more than about a third, the reduction is mostly contractual. If Scope 3 is more than about 70% of the total (the GHG Protocol notes that Scope 3 is the majority of most companies’ emissions), treat any Scope 1 and 2 target as covering the minority of the footprint.
The costliest mistake
Judging a company on Scope 1 and 2 alone. In the worked example, the company’s own operations produce 21,010 tons, 11.3% of its footprint; a “50% cut in operational emissions” would remove 10,505 tons, about 5.6% of the 186,010-ton total. An investor who buys a low-carbon story on that basis owns a value chain whose emissions, and the policy and demand risks attached to them, are almost untouched. Read Scope 3 first, then judge the operational target as the share it is.
7.2 How ESG Ratings Are Constructed
The idea in plain words
An ESG rating adds up many small scores into one grade, but providers answer different questions. MSCI grades a company against its industry peers, from AAA to CCC. Sustainalytics measures the absolute amount of risk the company has not managed. The ratings also rest on company disclosures, and the standards for those disclosures split between financial materiality, used by the ISSB, and double materiality, used by the EU’s CSRD.
Key points
■An industry-relative AA on an oil producer says it manages oil-industry risks well, not that it is low carbon.
■Unmanaged risk = exposure − managed risk; a weak manager in a low-risk industry can score better than a strong manager in a high-risk one.
■TCFD disbanded in 2023; its recommendations live on in ISSB’s IFRS S2, used or being introduced in more than 40 jurisdictions.
Decision rule
Match the rating to the question. If your question is “which company in this industry manages its ESG risks best?”, an industry-relative grade such as MSCI’s is the right tool. If it is “how much ESG risk am I carrying across industries?”, use an absolute risk score. If it is “what is this company doing to the climate?”, no rating answers it: go to the emissions data and, for EU reporters, the impact side of the CSRD double-materiality disclosures.
The costliest mistake
Using an industry-relative ESG grade as a carbon screen. Illustrative numbers: an oil producer and a software firm each have an enterprise value of $50 billion; the oil producer emits 20 million tons of Scope 1 and 2 a year, the software firm 0.2 million. A $100 million holding attributes 100 ÷ 50,000 × 20,000,000 = 40,000 tons to the investor in the oil producer and 100 ÷ 50,000 × 200,000 = 400 tons in the software firm, 100 times more, even if both carry the same AA grade.
What the full article covers
In the full article I take you through these sections:
■7.1 From Naming ESG to Understanding It
■7.2 How ESG Ratings Are Constructed
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, ESG Ratings Explained: How They Are Constructed, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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