Max Pacella
Investment Analyst
Multi-Asset
6 Dec, 2021

Last month, we discussed how you should scrutinise ESG investments and their classification, noting that it is entirely possible to come to different conclusions on the relative merit of one company using two different rating systems.

Which begs the question, how do those rating systems work?

From passive indexes to institutional classification services, there are many different lenses through which to view a particular company or sector for its environmental, social or governance characteristics.

Let’s look at the methodology and framework behind some of the best known ESG rating and index systems, in order to get a sense of how the ESG landscape is defined and measured.

The “Gut Feel” Test

Inaccurate and wholly unmathematical, the way you individually feel about an investment is still important to ESG criteria – what is and is not important to an individual about sustainability and social activity is subjective and continues to be a driving factor in ESG flows.

I used the example of sitting down over a drink to discuss Activision Blizzard (ATVI:NASDAQ) in our previous note on this subject, and for many investors that scenario may not be far from the truth.

Regardless of the scoring of the other tests or indexes in this note, choosing to invest into ESG is a personal matter for many people, and the “gut feel” test will inform much of where that investment will eventually end up.

Sustainalytics

Sustainalytics is one of the most widely known and employed rating methodologies for company specific ESG ratings.

The Sustainalytics ESG ratings are based upon three main factors:

  1. Corporate Governance; this is the foundational element in the ESG risk rating, with unmanaged Corporate Governance risk contributing ~20% of the overall risk score of the company.

  2. Material ESG Issues; analysis of these issues occurs at the subindustry level and then removed from an individual company if irrelevant. These are based on a common topic that requires a common set of management initiatives or oversight – for example, employee retention, diversity and labour relations all fall under the Material ESG issue of ‘human capital’, due to it being employee related and requiring HR oversight. These material ESG issues are able to be applied at an industry level, given their economic influence on a company can be fairly predictable.

  3. Idiosyncratic Issues; unpredictable or unexpected issues which are not typically found in that subindustry or business model, generally ‘black swan’ events which are largely externally driven by events outside of the company’s control.

The benefit of Sustainalytics is that it goes granular to the individual business and practice, whilst at the same time using an absolute measuring system so that you can compare a domestic energy company with a global tech company.

These risk scores are updated annually by a team of inhouse researchers, accompanied by AI analysis for quantative factors such as beta risk.


MSCI ESG Ratings

MSCI’s ESG rating system is similar to Sustainalytics and has formed the basis of some of their ESG indexes.

Their team measure the company’s resilience to long-term, industry risks concerning environmental, social and governance factors, through publicly available information.

The risks posed to the company are weighted based on MSCI’s view of which risks are more likely to have a larger impact, or an impact over a longer term horizon, with these weightings changing against the subindustry or business model. As an example, the below chart shows both general risks and key issues around a particular industry – the soft drinks industry (outlined in blue dotted border):

Source: MSCI

The companies are then normalised relative to the industry universe to form an overall rating:

Source: MSCI

ERIG Index

The ERIG index goes a step back from individual companies, and instead focusses on the ESG capabilities of managed fund products.

Managers are provided a comprehensive questionnaire (several hundred questions long), which forms the basis of the ERIG analysis and quartile ranking of the fund based on the following responsible investing capabilities:

  1. ESG Integration; applying ESG as a filter to your investment process
  2. Negative Screening; excluding companies or sectors from your investment universe
  3. NormsBased Screening; screens companies based on business practices/beliefs
  4. Active Ownership; using influence as shareholders to guide company ESG practices
  5. Positive Screening; aligning portfolio universe to target better ESG sectors/industries
  6. Sustainable Investments; specific targeting of sustainable themes
  7. Impact Investing; investments that have measurable social/environmental impact


Source: ERIG Index

The index then rates managers based against the entire universe and places them in quartiles – generally from what we have seen using this index, very few managers score highly on points 5-7, with 1-4 being easier to integrate into existing investment processes.


Source: ERIG Index

ERIG serves a different niche in being able to run analysis on a portfolio of managed products, understanding what your overall ESG profile might be from an investment manager perspective.

Indexes in General

We’ve discussed this previously, but knowing what is behind your investment vehicle is crucial to having a robust risk framework.

Even in my own research of this topic, I was surprised by the variance and inconsistency with which some ESG indexes are constructed.

It is helpful to know how certain index providers rate ESG generally (i.e. MSCI), but even then, their indexes may not be completely straightforward and transparent, depending on the specific focus or niche market they are looking to target.

For any investment strategy that follows a defined ESG benchmark, make sure to scrutinise what that benchmark proposes to track, and look behind to see which securities are actually captured – generally the gut feel test will help give you a sense of if that “ESG leaders” index is actually full of “ESG leaders”, or simply companies which can put a pretty coat of paint on an otherwise questionable model.

Rate My Virtues

If there’s a key takeaway from this note, it’s that investors owe it to themselves to have their good intentions most properly reflected in the investment vehicle they choose.

Over the Christmas break we are all sure to open up yet another pair of socks, boxers, a book that you’ll never read, or a jigsaw puzzle that will obviously get devoured by family pets (a certain colleague of mine will relate) – good intentions, poor expression of intention.

Sustainability and using our capital for good are noble pursuits and a growing focus of markets, but it remains important to understand what options are available and not take ranking systems at face value. Understand why someone got an A+, understand why another failed, and it will help shape your ESG investment universe more accurately for the future.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.