A New Approach to ESG Scoring

Scoring publicly traded companies on their environmental, social and governance (ESG) could now be easier following new research by Russell Investments. The firm has created a metric that more accurately identifies ESG factors which could impact the financial performance of the firms.

Scott Bennett, director of equity strategy and research at Russell Investments, co-authored a paper titled Materiality Matters: Targeting ESG issues that impact performance. “We can now distinguish those companies which score highly on ESG issues that are financially material to their business and profitability,” Bennett said. “Our material scores are 65% correlated to traditional ESG scores, but they are meaningfully different.”

The new scores allow ESG investors to differentiate between companies in a more precise way. According to Emily Steinbarth, quantitative analyst at Russell, who co-authored the study, the firm created the new scoring methodology with comprehensive ESG scores from data provider Sustainalytics, which "are used for a wide variety of reasons beyond investment selection, and the industry-level materiality map developed by the Sustainability Accounting Standards Board (SASB)."

The new scores were back-tested to a period between December 2012 and June 2017 using the Russell Global Large Cap Index. The research team found that a listed company's material ESG score offers a promising signal for informing investment decisions, producing measurably better performance than traditional ESG scores during the back-tested period.

Bennett added that the results of this study are aligned with the expectations of sustainable investment industry research organizations, such as the Task Force on Climate-related Financial Disclosures (TCFD) and the United Nations-backed Principle for Responsible Investment (PRI). These NGOs recommend that companies focus on the material ESG issues that directly affect their bottom line. An electric utility, for example, would make carbon emissions a material ESG factor in measuring the long-term impact on its ability to provide cleaner energy resources to business and residential customers.

Led by women and millennials, who will control the majority of wealth in the U.S. within 15 years, sustainability-focused investors are demanding more opportunity to incorporate ESG metrics into portfolio analysis. In turn, financial advisors are demanding better information from asset managers about how they use ESG analysis to reduce risk and create a performance advantage.

Publicly traded companies are next in line to be vetted in relation to ESG data, and today are more sensitive to investor demand for material information.

This change has been driven by rising importance of intangibles to publicly traded companies. According to David Post of the Sustainability Accounting Standards Board (SASB), intangibles now fill 80% of company balance sheets. This increases company exposure to short-term reputational risk. Internal focus on the ESG metrics that matter to a company today is, thus, more important than it was five years ago.  

As a materiality-focused approach to understanding ESG moves to center stage, large asset managers are calling for awareness of which off-the-balance-sheet issues create risk and opportunity for firms. In a recent letter to the CEOs of companies owned in its portfolios, BlackRock CEO Larry Fink recently drew attention to “A New Model for Corporate Governance” focused on long-term value creation for shareholders. (See also: Amplifying The ESG Definition.)

BlackRock’s assets under management are heavily weighted toward index-based, low-cost portfolios. In passive portfolio structures that incorporate ESG analysis, asset managers cannot express disapproval of corporate governance policy decisions by selling a company’s stock as long as it is included in the relevant index. This potentially impacts the asset manager’s fiduciary obligation to its shareholders.

Fink’s remarks are especially valuable to consider in relation to research of the kind that Russell Investments has done to develop company and industry-specific ESG metrics that affect performance. Accurate measurement of material ESG metrics at the company level is more important than ever. In fact, the early results of this research have encouraged Russell Investments to incorporate the new material ESG scoring approach into its current decarbonization strategy. This strategy serves as the foundation for low carbon investment funds available in several markets globally.

The research also confirms a founding premise for the work of the SASB since its inception, which is that markets don’t need more ESG data, they need better ESG data for investors to use in the portfolio securities selection process. (See also: Merrill Edge Adds ESG Scores to Platform for Impact Investors.)