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How should investors use ESG scores?

Investment Pensions & benefits

How should investors use ESG scores?

ESG scores have received a lot of negative press lately. They even drew criticism from Elon Musk after an ESG score downgrade for Tesla led to its removal from a popular ESG equity index. The lack of consistency across providers for individual companies’ ESG scores has been widely criticised, but is it justified? Given their widespread use, we had a deeper dive into some of the different ESG scores available to find out how they can be useful for investors.

What did we look at and why?

We reviewed a group of ESG scoring providers relevant to our clients, including both data providers and investment managers.

Our focus, initially, was on the ESG scores’ suitability for use in index-tracking products, such as ESG equity index funds. These funds track an index which might start with a standard market-cap weighted equity index, then tilt towards companies with higher ESG scores and tilt away from (or exclude) those with lower ESG scores.

We chose to focus on this use case because the scores are often used to construct a portfolio in a formulaic way without the ability to deviate from the rules based on expert judgement. Therefore, we expect that this is an area where the ESG scores could have a significant financial impact on investors’ portfolios.

Almost all investors have financial objectives, so for index-tracking products, they should consider the potential effect on financial performance of using ESG scores in the construction of an index. With this in mind, we focused our review on assessing whether any of the chosen ESG scoring systems could effectively capture a company’s exposure to financially material ESG factors.

Our key conclusions

  • In our opinion, none of the ESG scoring methods we looked at could adequately assess financially material ESG factors. In some cases, this isn’t what scoring providers are trying to achieve.
  • We believe that the scores should only be used by investors if they are overlaid with judgement. This means that, generally, we believe they are not suitable for use in index-tracking products, although there are some exceptions.

Taking a step back, what is an ESG score?

Broadly speaking, an ESG score is a composite rating of a company’s environmental, social and governance credentials. The scores are typically assigned to companies, such as Apple or Tesla, to show how they are managing a wide range of environmental, social and governance factors. There are several providers in the market producing ESG scores, and investors can access these scores and the research backing them up. Some investment managers also produce ESG scores in-house for their own use.

What do we think would make a ‘good’ ESG score?

We assessed against two key factors:

  • The objective of the scoring methodology - we considered what the scoring provider was attempting to achieve and how this compares with our preferred objective of capturing financially material ESG factors.
  • The scoring process - we then assessed the scoring process in detail and how well it fulfilled its stated objective. This involved looking at factors such as the level of resourcing, the data sources used, the relative importance placed on different ESG factors and the outcome of applying the process to some example companies.

ESG scores are deliberately not the same

A key point to highlight is that different ESG scoring providers have different priorities and objectives for their scores, and consequently they use different methodologies.

In terms of the ESG indicators considered in their methodologies, there are those disclosed by companies - for example, reported greenhouse gas emissions for the previous year or policies indicating how the company is run -– as well as alternative data sources either measured or estimated by external providers. Different methodologies may include a mixture of objective assessments of data points and subjective assessments, such as the potential future impact of certain ESG factors on a company’s financial performance.

So, we believe it is important that any application of ESG scores should start with an understanding of what the provider is trying to achieve, otherwise it might lead to an unsuitable application.

Our findings

Assessed against our two key factors, we found that:

  • The objectives of the scoring methodology – some, but not all, of the scoring systems were consistent with our preferred objective to assess financially material ESG factors.
  • The scoring process – where the scores were consistent with assessing financially material ESG factors, we had concerns about whether the methodology was effectively following through on this objective.

In our view, none of the different ESG scoring methods we reviewed could adequately assess financially material ESG factors for a company.

We reviewed each of the scoring methodologies in detail and looked in depth at a few common company-level examples. In the examples, we found that the scoring process can be limited where a company’s exposure to a certain ESG factor is not easily quantified, or where the data does not yet exist. Relevant data might just be very hard to obtain, for example for companies with complex supply chains. In other cases, appropriate data might never exist. One example might be the difficulties in trying to measure the impact that social media companies have on the wellbeing of their users. As a result, we think there are some gaps and shortcomings in the process that could miss or misstate exposures to material risks.

It is not all negative. We saw plenty of evidence of scoring providers carrying out useful and in-depth research to support their scoring. Research that considers an impressive range of indicators and ESG factors. But ultimately, we think that these scores should only be used by investors if they are overlaid with judgement and discretion.

We, therefore, concluded that the scores are not suitable for index-tracking products, at least in cases where the use of the ESG scores in the construction of the index significantly changes its risk and return characteristics relative to the parent (eg market-cap weighted) index.

It is also important to acknowledge that different investors might have different investment objectives or beliefs, and ESG scores can be used in lots of different ways. For example, there are index-tracking products available that target a modest tracking error relative to the parent index, with an aim to replicate its risk and return characteristics but with a better ESG profile. In these cases, we think the use of ESG scoring may be reasonable if an investor wants to invest in companies that better align with its own objectives.

We believe there are many other applications where the scores can be useful, here are a few:

  • We support the use of ESG scores by active managers in the investment process to help make investment decisions informed by ESG factors, as long as the manager’s expert judgement is overlaid onto any investment decisions.
  • For investors, these scores can be a useful tool to monitor the ESG characteristics of a portfolio at a high level, and to highlight specific areas of potential concern to inform discussions with investment managers.
  • For defined benefit pension scheme trustees, ESG scores can be a useful tool to provide an external view of a sponsoring employer’s ESG risk exposures, if used in addition to input from a suitably experienced covenant advisor.

How do you currently use ESG scores?

It may be time to consider how much ESG scores are currently used within your own portfolio, or even if you could use them to better understand your exposure to ESG risks and opportunities and inform engagements with your investment managers. If you are invested in a passive ESG equity product, we think understanding how ESG scores are used in the product and how much they influence the portfolio would be a good place to start.

For more information on any of the topics referred to in this blog, please get in touch with our Responsible Investment Team.