By Ruben Haalebos and Kevin Ratsimiveh, data scientists
The explosion of interest in sustainable finance has seen investors stampede into the sector and providers rush to bring products to market to meet demand. It has also shone a spotlight on a nascent part of the financial world. Inevitably, this process has revealed misunderstandings and misapprehensions about some of the key tools that investors can use to understand the sustainability or otherwise of their investments.
Take environmental, social and governance (ESG) scores. Much like a credit rating, these offer a single score that aims to capture how sustainable a particular issuer is. A credit rating, however, estimates the probability of a single outcome: that an issuer will default on its debt within a given time period. An ESG score, meanwhile, seeks to aggregate hundreds of individual environmental, social and governance indicators into a single measure.
It is important, then, for investors to understand the methodologies that inform each provider’s ESG scores, what biases they may suffer from, and what the scores do (and do not) tell them.
At FTSE Russell, we emphasize objectivity and transparency in the data we provide to our clients. This is particularly important in an emerging field such as sustainable finance. To that end, we have recently undertaken two studies that aim to illuminate how our ESG scores are constructed, and how investors might best understand the insights they contain.
The first sought to dig into the effects of specific biases in ESG scores. It has been widely observed that larger companies, those based in developed economies, and those in particular sectors tend to obtain higher ESG scores. The reasons could include the greater resources available to larger companies, the greater volume of ESG-related regulation in richer economies, and the greater environmental and social impact of, for example, heavy industry versus the technology sector.
Our research thus sought to identify, using rigorous statistical analysis, the contribution that size, country and activity factors make to an ESG score, and the contribution of the specific sustainability efforts and performance of the issuer.
Using an optimized Partial Least Squares regression method, we were able to isolate the effect of these three factors versus residual scores, which represent the ESG performance of each company independent of those factors. On average, the three factors explain around half of the ESG score.
This exercise allows investors to fully or partially control for these biases in, say, a smart beta index if they choose. However, it should be noted that these biases do contribute to ESG performance, and investors may wish to accept them in portfolio construction. Either way, a deeper knowledge of how an ESG score is constructed can only benefit the user.
Similarly with understanding the role of the various themes in an ESG score. The second paper examines the contribution that each of the 300 ESG indicators that we tracked, grouped in 14 themes, makes to the ESG score. These themes include climate change, labor standards, water security, biodiversity, tax transparency etc.
Intuitively, some themes will matter more to one company than another. Health and safety will be a bigger issue for a construction company than for a financial services group. Water security will be of greater concern to a brewer in India than for a similar company based in Canada.
However, again using a partial least square regression analysis, we found that just six themes explain a big part of the ESG rating for most companies. These are: climate change; environment supply chain; anti-corruption; labor standards; human rights and community; and social supply chain. This opens the door for the construction of “reduced ESG ratings,” using fewer indicators that might be sufficient for more generalist investors to use.
This is not to say that the other themes do not add analytical value. For more specialist investors who want a more granular picture of ESG risk and opportunity, it will be necessary to look beyond the headline ESG rating to investigate issuer-specific ESG themes that might not be adequately captured.
This speaks to the fundamental nature of ESG rating– that they aggregate hundreds of indicators into a single output. They cannot be expected to capture every nuance of an issuer’s ESG position and performance. ESG ratings offer an invaluable starting point for assessing sustainability, but they are a long way from the end of the journey.
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