Don’t settle for ESG rankings. Focus on materiality instead.

Do investors know what’s going into their ESG funds?

The Wall Street Journal ran an article about how environmental and climate funds dominate ESG. It’s clear that more and more investors, both in the institutional and retail space, want to reduce the carbon footprint of their portfolios and place environmental issues at the center, not periphery, of their investments. But do investors know what’s going into their ESG funds?

A common pitfall in ESG investing is the profusion of standards and metrics for what qualifies as an environmentally friendly company. For instance, consider an oil-and-gas producer that currently has a high carbon footprint but is making big strides in shifting to renewable energy and shows promise for greater sustainability in the future. A traditional decarbonisation approach, which focuses on bluntly reducing exposure to carbon emissions or divesting from fossil fuel reserves, may miss out on this plum green opportunity, as renewable energy production is actually correlated with high emissions.¹ Compare this with a digital technology company that may have ambitious carbon neutrality targets and a lower carbon footprint but is underreporting greenhouse gas emissions found along its value chain.² Or, further, consider a fund manager that, on top of ranking companies based on sustainability criteria, utilises governance tools, such as engaging with shareholders or actively voting at annual meetings of the companies it invests in, to effect positive change.

What this means is that we cannot judge ESG funds at face value and need to dig deeper. Which names do they hold? And why were those names chosen? Were companies selected just because they happen to be low carbon emitters? Is that how we think a company should be judged? Or did they score well on some ESG rating methodology with a few hundred inputs?

Rather than adopt a one-size-fits-all approach, we think it pays to focus on the type of ESG investing, whether it’s ESG investing for impact or ESG investing for financial materiality. At Russell Investments, we specifically wanted to find an investment signal that homes in on the ESG issues most relevant to a company’s bottom line - in other words, a signal focused on financial materiality. To that end, we developed our materiality score, which looks at the small subset of sustainability issues that are relevant and specific to a particular company. Ultimately, when it comes to adding ESG considerations to an investment process, we think that materiality matters.

Not all ESG issues matter equally

However, the relevance of ESG issues varies from industry to industry, company by company. For example, fuel efficiency has a bigger impact on both the carbon footprint and the bottom line of an airline than it does for an investment bank. If a bank says it has reduced fuel consumption by 50%, ESG investors should not hold their breath waiting for the bank’s share price to go up. If an airline makes the same claim, ESG investors should pay attention. Rather than looking at the same issues for every single company, we developed an ESG scoring methodology that is truly material to companies.

Why? We have found that traditional ESG scores are composed of a large number of issues that are not material for every industry or company, including large technology companies. In 2018, when we first conducted our original research, we found that for two-thirds of all securities in the Russell Global Large Cap Index universe, less than 25% of the data items in the traditional score were considered material.

When we first launched our materiality score in 2017, we leveraged the ESG data from the data provider Sustainalytics alongside the industry-level materiality map developed by the Sustainability Accounting Standards Board (SASB). We found that this new combined score helped to serve as a keen ESG signal for investment decision-making. But even then, we knew we could make that score even better.

Material ESG score update

ESG investing is a rapidly evolving space, and in 2019 we released a major enhancement to our material ESG scores: We worked with overhauled methodology from our data provider, Sustainalytics, and an updated Materiality Map from SASB. These data changes presented an opportunity to incorporate several methodology upgrades, including:

• The addition of a corporate governance score for all companies
• Sourcing environmental data from multiple providers
• More emphasis on forward-looking information where available

Incorporation of a corporate governance score

We found our original materiality score based on the SASB framework to be lacking some of the corporate governance information that we think matters. Our solution was to supplement the SASB framework with an additional pillar of corporate governance for all companies.

For the governance metric, we use a comprehensive corporate governance assessment from Sustainalytics. The new metric more closely aligns with our proxy voting practices, including an assessment of board and management quality, board structure, shareholder rights, renumeration, audit and financial reporting and stakeholder governance.

Sourcing environmental data from multiple providers

We also expanded our access to a broader data set from a broader range of providers. One of the fundamental shortfalls with ESG data is data quality. Moving to a model where raw data can be used from a variety of providers allows us to capture unfiltered data, with a quicker time from disclosure to incorporation in the score.

Addition of a forward-looking adjustment

Because one of the major criticisms with the current state of ESG data is the focus on backward-looking information, we addressed the question of what we could do to make our assessment more forward-looking.

To that end, we added a forward-looking lens to our ESG data research. We identified three pillars where forward-looking information is most relevant, and where data is available. These include greenhouse gas emissions, water management, and business model resilience. Business model resilience includes indicators of how a company is preparing its business model for sustainability issues, such as a transition to a lower-carbon economy. For greenhouse gas emissions and water management, we look not only at the company’s current performance but also at the direction of trends for the company. Is its water management improving or getting worse? What about targets? Has the company set an aggressive target to have zero emissions by a specific year? These are the types of details that help build a picture not just of where the company has been in the past, but the direction in which it is headed for the future.

How did the material ESG scores change?

The correlation between the new and old scores is 0.47 - in other words, the new and old scores are moderately correlated and, in some cases, score changes were significant. So what changed? Here are the most common themes we saw in the before-and-after comparisons:

• Corporate governance – Our greater focus on measuring corporate governance boosted the score of companies with strong management and lowered the score of several companies with weak corporate governance.
• Less reliance on voluntary disclosure – The addition of more performance-based metrics meant less reliance on voluntary disclosure by companies and more balance between voluntary disclosure and actual performance.
• Open-sourced data – Moving to open-sourced data led to better coverage, more recent data, and in some cases, more accurate assessments.
• Availability of new indicators – More data is now available on some topics whose relevance is increasingly being recognised: data privacy and security, competitive behavior and systemic risk management.

Three case studies of big score changes

1. Under our previous scores, a multinational mining, metals and petroleum company scored a 7 out of 10. With our increased focus on performance outcomes instead of voluntary disclosures, this company’s score reduced to a 3 out of 10. In particular, sub-scores on topics including air quality, ecological impacts and water and waste management - where the company had strong disclosures but had been involved in major incidents - declined, leading to a lower score overall. This reflects the shift from disclosures to performance.
2. A multinational pharmaceutical and life sciences company’s score changed from 1 out of 10 to 8 out of 10. Changes to the materiality mapping were the primary drivers behind the change. Previously, waste, water and energy management were all considered material, and the company scored poorly on these issues for lack of disclosures. Under closer materiality scoring analysis, these were no longer considered material pillars for this specific company.
3. A global financial services company known for its credit cards increased its score from 4 out of 10 to 8 out of 10. The addition of data privacy indicators to the Sustainalytics data significantly helped this score, as the company notably had a lack of incidents related to data security and customer privacy, especially compared to its peers.

Changes of this magnitude were uncommon, but these examples hint at the overall trend we are observing: a fast-paced improvement in the ability to measure ESG performance. While this is our latest enhancement, we have no expectation that it will be our last.

The impact on investors

What does this all mean for ESG investors? For us, it means that an ESG portfolio doesn’t need to be tied to one single idea. Instead, ESG investing can be a new way of thinking about every single company in the portfolio. The beauty of this model is that the investor can incorporate ESG in a way that is laser-focused on the bottom line. Are we saying financial materiality is the only reason to incorporate ESG considerations? No. But the ability to move beyond the broad heading of ESG into more specific types of indicators - such as those focused on financial materiality - is an important step in greater transparency around ESG funds.

For some investors, this is exactly what they are after. For others, it’s not. We think that when it comes to ESG, you can have your cake and eat it too. But let’s be transparent about what that means: There can still be names in the portfolio that don’t scream ESG to the casual observer. The key is understanding whether those companies are held because they were doing well on the ESG issues that mattered to them, or because they happened to have lower emissions than, say, an oil-and-gas company. We would argue that doesn’t tell you much about whether the technology company is actually sustainable.

The bottom line

Investors should be aware that ESG investing is still evolving, especially when it comes to the data-driven accountability that is required to gain an accurate picture. Whatever the motivation for exploring the environmental, social and governance characteristics of a portfolio, we believe a focus on materiality - on the relevance and significance of ESG issues - is one of the best ways to increase both transparency and impact.

For more information on how we measure a company’s ESG score through a materiality lens, check out our paper, Materiality Matters.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.