In previous blogs, we’ve identified some of the data issues associated with ESG investing and offered some ways to address them. Here, we present some simple hypothetical portfolios that will help demonstrate many of the observations made above regarding data challenges and analyzing the available data to identify stable characteristics. In this case, we find that:
- Even a naïve pillar filtering can boost overall scores.
- The pillars are largely independent of each other.
- Most of the risk is due to systematic factors.
Data and Methodology
We look at the MSCI ESG ratings, widely employed by many investors, partly because it is one of the most reliable, comprehensive, and extensive datasets available. Even so, the data only start in 2007 and really only reach a high degree of coverage by 2013 (see Figure 1). The plateau in coverage setting in then suggests that there was a change in the implementation of the overall model.
While MSCI’s ESG analysis does include a deeper, more granular assessment of each of the ESG-related ‘issues’, we will limit ourselves to a focus on the higher-level scores for the three pillars (E, S, G) and the composite ESG score. All four scores take values in the range of 0-10, with 10 being the best.
In addition, we look at the MSCI Carbon-Intensity data, which start in 2009, and reach a high degree of coverage by 2015 (see Figure 2). Carbon Intensity (CI) represents carbon emissions normalized by a measure of the size of the company, so that large companies are not penalized just for being large. As in Figure 1, the plateau in 2015 suggests a change in the implementation at that time.
The Carbon Intensity data do not represent a grade but normalized carbon emissions, so they have no upper bound; in fact, the range of values spans many orders of magnitude, with some stocks being extremely high outliers in the universe.
On a monthly basis for each of the 5 metrics (the composite ESG rating, the 3 individual ‘E’, ‘S’ and ‘G’ pillars, and the Carbon Intensity), we construct hypothetical portfolios containing the ‘best’ rated half of the stocks in the MSCI All Country World Index (ACWI) for each measure, weighted by capitalization.
As you might expect, keeping only the top half of the index stocks by ESG score boosts the ESG rating of the resulting portfolio (by 1-2 units relative to the index on the rating scale of 0-10), but also boosts all the three pillar scores and suppresses CI, albeit by differing amounts and with varying consistency (see Figure 3).
It is worth pointing out that the sharp change in the benchmark-weighted G score in 2015, which cannot be explained by intrinsic market changes, is due to a model change, demonstrating again the self-consistency issues we mentioned earlier.
Keeping the top half of the index stocks by ‘E’ score boosts the ‘E’ rating of the portfolio relative to the index by about 1 unit, but it also boosts the composite ESG score and suppresses CI (see Figure 4). However, it doesn’t consistently boost the ‘S’ or ‘G’ scores.
Keeping the top half by ‘S’ score boosts the ‘S’ rating of the portfolio relative to the index by about 1 unit on average, and it also boosts the composite ESG score (see Figure 5). It doesn’t consistently affect the ‘E’ or ‘G’ scores, or CI.
Keeping the top half by ‘G’ score boosts the ‘G’ rating of the portfolio by about 1 unit relative to the index, and it also boosts the composite ESG score (see Figure 6). However it doesn’t consistently boost the ‘E’ or ‘S’ scores or suppress CI.
Keeping the bottom half of stocks by CI suppresses the CI of the portfolio by 80-90% relative to the index and boosts the ‘E’ score (see Figure 7), albeit not consistently. It doesn’t significantly affect the composite ESG, ‘S’ or ‘G’ scores.
Unsurprisingly, concentrating the portfolio in stocks of a particular type boosts the rating used for the sorting. However, it is important that, in all cases of even this simple approach of keeping the top half of the stocks, it results in a stable boost (a relatively consistent difference from the total benchmark rating over time).
This analysis also demonstrates that the individual ESG pillars are quite independent of each other e.g., a stock with a high ‘E’ score doesn’t necessarily exhibit a high ‘S’ score. This is particularly the case in the recent past, which is partially a reflection of the continued evolution of the MSCI ratings model, and its increased coverage.
A deeper look at the characteristics associated with these simple portfolios exhibiting ESG composite and pillar tilts reveals the persistency and dominance of some systematic factors. This is further evidence that a portfolio-level approach can encapsulate most of the important insights, and that stock-specific information, while meaningful, is not as vital for ESG integration. In particular, expressing the stable characteristics of the ESG ratings in non-ESG terms allows for a reliable extrapolation over a more extensive history than is available through the MSCI database.
Seek Problems and Solutions
Like the financial data investors are used to processing, we’ve shown some ways that ESG data is independent and the ways it behaves similarly. For more information on the specific shortcomings commonly associated with available ESG data – and some potential solutions – check out our latest paper, Overcoming ESG Data Challenges.
The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions. The information, analyses, and/or opinions expressed are not intended to provide any specific financial, economic, tax, legal, investment advice, or recommendations for any investor. It should not be relied on as the sole basis for investment decisions. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained herein. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed. Past performance is no guarantee of future results. Investing involves risk, including fluctuation in value, the possible loss of principal, and total loss of investment.
The hypothetical portfolios shown are for illustrative purposes only and do not represent any particular investment.
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