Responsible Investing – Risks, biases and understanding ESG data
For investors looking for equity exposure many now include Environmental, Social and Governance (ESG) considerations into the decision-making process. The investing landscape has changed significantly, in part due to new regulatory initiatives such as measuring and understanding the impact of climate change from an investment. We will provide a guide for investors on how to interpret ESG data points for stocks and funds – which in many situations can be confusing for advisers and investors alike.
There have been many academic studies that have reviewed the ‘alpha signals’ from funds with specific ESG objectives. The findings from such studies have been mixed, in part due to ESG based strategies having different types of ESG objectives, or differences in the way ESG is used in the pursuit of alpha or excess returns. However, one thing that most studies do agree on is that ESG data across providers is lowly correlated with one another. This just adds to the confusion for advisers and investors who are often reviewing ESG investing for the first time.
As an example, Russell Investments uses data from two of the leading ESG data providers Sustainalytics and MSCI. This data is used monthly to measure the ESG characteristics of all Russell Investments equity funds globally. To demonstrate how this is applied let’s take a look at the Russell Investments Australian Responsible Investment ETF (RARI).
|ESG risk score||21.6||23.9||99.4%|
Source: Russell Investments (Sustainalytics and MSCI data as at 31 May 2021)
The above data shows RARI has an ‘ESG risk score’ that is 10% BELOW the benchmark and a carbon footprint that is 39% lower. A low ESG risk score is desirable and, hence, these are exactly the kind of ‘ESG outcomes’ an ESG minded investor would expect and is driven by the fossil fuel exclusion in RARI.
There are many types of ESG risks, and most will have a specific Environmental, Social or Governance related theme. The above ESG risk scores are calculated using Sustainalytics data and are the ‘Material ESG Issues’ that are deemed ‘unmanaged ESG risks’ that occur from specific sector-based (and industry driven) exposures. Categories for the ESG risks are shown below.
RARI v S&P/ASX 200 – Material ESG Issues summary:
Overall RARI has lower ESG risks than the benchmark, but higher exposure in some categories. We can drill down to stock level ESG risks and which areas of ESG those risks reside. This assists with our active ownership, i.e. our proxy voting and engagement activities to identify what areas our engagement with companies should focus on.
ESG risk is just one lens and is normally complimented with outright exclusions, as we do for RARI with fossil fuels, alcohol and gambling related exclusions. We are receiving increasing feedback from investors and advisers that they are looking for positive tilts, or specific ESG related areas of impact from their investments. Examples here would be exposure to renewable energy or healthcare focused solutions.
Russell Investments’ low carbon investment strategies use a green energy metric to increase a portfolio’s exposure to renewable energy. With this strategy there is also a positively tilt to broad ESG scores, relative to benchmark, to ensure a fund’s overall ESG characteristics are higher than its benchmark. It is important to note that the ESG scores here are an aggregate measure of how ‘well’ a company rates on overall ESG metrics. In this case a high ESG score is desirable.
This is the approach used for RARI too. Negative screens are used to avoid industries that cause harm (like alcohol and fossil fuels) and a tilt to ESG scores is used which improves the portfolio’s overall ESG attributes:
Source: Russell Investments (Sustainalytics and MSCI data as at 31 May 2021). Data is relative to the ASX 200. The official benchmark for RARI is the Russell Australia ESG High Dividend Index but here we are showing performance against the ASX 200 for the purposes of carbon and ESG metrics.
The above metrics are published on our website monthly in the fund factsheet. We do not currently publish the RARI ESG risk score externally, shown earlier in the blog, as this is NOT used in the portfolio construction process. The different ESG scoring methodologies highlight the challenges of understanding ESG attributes of specific funds.
Investment outcomes, and biases from ESG investing
As highlighted above, and in my blog earlier in the year, ESG investing can result in unintended biases in portfolios. For example, screening out fossil fuels can lead to style risks as funds will become naturally overweight to certain sectors to accommodate excluding others. In addition, ESG scoring can often have biases too – the ESG risk scores highlighted above are normally higher for mining/fossil fuel related companies. RARI has a lower ESG risk score helped by its fossil fuel exclusion, however, it also scores well on the other three ESG metrics above that appear in our monthly factsheet. Using multiple lenses to understand the ESG characteristics of a fund is important.
With the seismic shift of assets into ESG based strategies, there has inevitably been concerns around greenwashing (the overstating of a products ESG credentials). ESG metrics are not always intuitive, and a high-level summary of key portfolio characteristics is a helpful tool for investors. The table below highlights the top three investment outcomes and exposures an investor in RARI will have:
|EXPOSURE SKEW||DRIVER||INVESTMENT OUTCOME|
|Underweight to Materials and Energy sectors||Fossil Fuel Exclusions||Lower carbon emissions relative to benchmark and nil exposure to Carbon reserves|
|Overweight to Financials||Tilt to yield in the portfolio construction process, also many stocks have ESG scores above benchmark||Overweight to the ‘Value’ factor (and underweight ‘Growth’)|
|Overweight to REITs||High ESG scores, above average yield from REITs||Overweight to the mid-cap part of the Australian share market, superior ESG characteristics|
REIT refers to Real Estate Investment Trust.
As an increasing number of investors access ESG based strategies there is a growing need for more education on how portfolios are constructed, and the ESG outcomes investors can expect. Using multiple sources to measure ESG outcomes of portfolios should be the absolute minimum due diligence for such strategies. Fund ratings providers (research houses) will normally do this, but the comparison of how competing products measure up against each other is still largely something individual investors will need to do.
For many advisers, it is about understanding how “light” or “dark” green your client is and being able to identify and match the appropriate investment and exclusions to this and their risk appetite. Key to this is understanding the data that is available along with the benefits and limitations of the data in relation to each fund.
Finally, it is worth highlighting that ESG data is largely backward looking. Hence, whilst metrics like those shown in the blog are very useful for portfolio level risks, more detailed insights into specific company level ESG characteristics normally requires broader conversations. Partnering with a product provider with deep ESG knowledge will help in this regard, and this is an area Russell Investments has invested in extensively over recent years.
* We define relative carbon emissions as Scope 1 (direct) carbon emissions plus Scope 2 (electricity consumption) carbon emissions measured in metric tons of carbon dioxide equivalent (CO2-e), divided by company revenue (USD).
** We refer to relative carbon reserves as the asset relative fossil fuel reserves of a company. Specifically it is defined as: Fossil fuel reserves (m tonnes) divided by total company assets (USD).
~ The ESG score is provided by Sustainalytics.