What is an ESG rating and how is it built?

The dialectic of green and sustainability in general is increasingly permeating numerous fields. Finance is no exception. In the economic world, we increasingly hear about ESG evaluations or ratings that help all stakeholders make more ethical and profitable decisions. But what is an ESG rating, and above all, what is its purpose?

It’s no longer news that the growing impacts of climate change have thrust sustainability into the center of the global debate, not only environmentally but also financially. The awareness of the enormous risks these changes pose to the economy and the financial system has driven interest toward a new perspective: sustainable finance. This approach, based on environmental, social, and governance (ESG) indicators, has transformed the financial ecosystem into a terrain where investment decisions reflect ethical and sustainable values.

While governments play a key role in mitigating climate change through incentive and regulatory policies, sustainable finance offers investors a powerful tool to shape the future. Investing according to ESG principles means supporting companies that adopt sustainable practices and respect human rights, promoting the achievement of the United Nations’ Sustainable Development Goals.

As a result, the exponential growth of sustainable finance has also catalyzed attention at the regulatory level. The European Union is leading the way with regulations on sustainable finance, having introduced the EU taxonomy, the Corporate Sustainability Due Diligence Directive (CSDDD) and numerous other standards to ensure the completeness and quality of information. The recent Corporate Sustainability Reporting Directive (CSRD) aims to put an end to greenwashing and strengthen the EU’s social market economy. As such, from 2024, some companies will be required to adopt specific reporting policies to demonstrate the impact of their activities on the environment, communities, consumers, and employees.

Sustainable finance emerges as the essential link between the world of investments and the creation of a sustainable future. In this context, green finance is not just an investment choice but a key to building a fairer, more prosperous, and environmentally respectful world.

The tools playing the most relevant role in the field of sustainable finance and contemporary business context are ESG evaluations. A sustainability-focused approach, while considering challenges related to limited resources, is imperative for long-term growth and efficiency.

The ESG rating, an increasingly relevant evaluation, measures the solidity of a company on environmental, social, and governance fronts. The analysis of these three factors, not replacing but complementing traditional financial indicators, provides a comprehensive picture of investment sustainability.

ESG ratings offer tangible benefits, including transparent governance models, clear measurements of environmental and social impacts, and indicators of long-term sustainability. Transparency and disclosure are essential to ensure the trust of investors and stakeholders. 

This evaluation has become a key tool for sustainable investments, directly influencing the market’s perception of corporate resilience. While Artificial Intelligence promises to play an increasingly relevant role, future trends suggest a significant increase in sustainable investments and greater standardization of sustainability assessment practices.

In this emerging theme of sustainability, a myriad of choices extends before companies, within which navigating could prove to be quite complex.

modefinance’s proprietary ESG rating model represents a tool for evaluating and understanding a company’s ability to effectively integrate sustainability-related risks and opportunities into its development framework and strategic planning. This approach, viewed from an “Exposure Vs. Management” perspective, allows for the analysis of the company’s capability to balance the environmental, social, and economic impacts related to its activities.

The modefinance model stands out for its dual nature, both financial and technological, due to the combination of cutting-edge artificial intelligence technologies and the traditional approach to financial analysis, providing an unprecedented level of detail both quantitatively and qualitatively. Moreover, the digital perspective of the model allows for its application to both large enterprises and SMEs, offering a comparison with the reference peer group through collected data and implemented statistical logic. As already a rating agency, modefinance integrates its know-how in the ESG field with its experience in the Fintech world, thus offering a unique added value in its kind.

The process of formulating the ESG rating by modefinance is guided by a methodology that is structured in several phases:

1. Check list: in this initial phase, the analyst proceeds with the collection of public documentation, ranging from the financial statement to sustainability reports (if available) - and involves other types of documentation - analyzing numerous aspects such as the size and sector of the company, in order to identify the main aspects related to sustainability and any ESG risks it may be facing. Additionally, the analyst carefully examines financial data, evaluating their structure and paying particular attention to possible negatives and controversies.
2. Guidelines: the second step consists of a preliminary materiality analysis, preceding the interview with the analyst. This evaluation involves a detailed study of the significant themes for the company’s activities, as well as for the sector and territory in which it operates, in order to structure the qualitative interview questions tailored to the entity being rated. However, this does not imply that the rating is limited to highlighting only the positive actions of the company, neglecting those that have not been implemented or are not equally virtuous.
3. Interview: It consists of one or more dedicated conversations with the representatives of the respective E, S, and G themes – depending on the company’s structure and the sections involved. The questions, customized in the previous step, are a structural part of modefinance’s proprietary model, which constitutes the core of the process. This model provides individual scores associated with each pillar, ultimately leading to a weighted final score.
4. Analysis: In this section, the analyst is required to conduct an adjustment of the final judgment obtained through the model, taking into account all the information collected about the company, based on the characteristics of the operating sector, the territories where the company operates, as well as based on the feedback from the questionnaire and supporting documentation.
5. Final evaluation: Drafting of a report by the analyst containing an extensive investigation into the three pillars of sustainability and assigning the respective score.

The final rating is summarized into one of three macro-areas – Vulnerable, Responsible, Dynamic – which are further divided into seven rating tiers, ranging from S7 to S1 (from worst to best, respectively).

In conclusion, it cannot be stressed enough that sustainable finance is emerging as a crucial pillar for ethical investment and the construction of an environmentally responsible and economically stable future. In this context, the ESG rating is rapidly establishing itself as a fundamental tool for companies seeking to assert themselves and improve their reputation in the market. Consequently, with the increase in awareness and regulation, investing sustainably, as well as affirming one’s degree of sustainability, becomes not only a choice but an imperative for a fair and prosperous future.

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