‘E’ Is For Environmental

February 27, 2020

[This article appears in our March 2020 issue of ETF Report.]

 

Climate change has become a major concern for many investors, as more people consider the record-breaking summer heatwaves in Europe, massive hurricanes in the Caribbean in the past few years, and the Australian wildfires as more than weather oddities.

For many environmental, social and governance (ESG) investors, the “E” is paramount. Meggin Thwing Eastman, executive director and research editorial director for MSCI ESG Research, notes their clients’ No. 1 environmental issue is climate change.

Yet finding ETFs with the highest environmental ratings can be tricky. Investors first need to decide what their top environmental concerns are: Is it carbon emissions? Water quality? What about deforestation?

Ratings from ESG data providers can help, but the data they use and their methods aren’t standardized. Research Affiliates notes there are 70 firms providing ESG ratings, not including other organizations conducting ESG-related research, all with their own ideas of what ESG means.

But there are ways for investors to discover the highest-rated environmental funds that align best with their views. It just takes a little legwork.

Creating Ratings
Eastman says that MSCI’s flagship ratings methodology assesses the long-term resilience of companies. Regarding environmental ratings in particular, MSCI looks at what issues are most financially relevant for a firm. For example, a miner would have several environmental risk issues, so MSCI will assess those risks in different ways, and the firm’s environmental score could have a heavier weight in its overall ESG score.

MSCI reviews a company’s operations, business segments and the typical profile of those segments. They also consider the individual firm’s risk exposure within its industry compared with its peers and how the company manages those risks.

That process is repeated for different issues across “E,” “S” and “G,” with the riskiest aspects getting the greatest weights. Those are averaged together and weighted for an overall company rating, and one that’s relative to the rest of the industry. The scores are rated 1-10, with 10 being the highest, and from AAA to CCC, similar to credit ratings.

For ETF ratings, Eastman notes that the fund’s underlying holdings drive quality ratings. There’s a weighted average of the holdings, and MSCI adds a momentum factor for funds, giving a slightly higher score to a fund holding companies with improving ratings, compared with a fund whose company ratings have declined over time.

Dig Deeper
For investors, taking ratings at face value is just the start. Feifei Li, head of investment strategy at Research Affiliates, recently published an article, along with her colleague Ari Polychronopoulos, comparing ESG ratings between two well-known providers.

The article, “What a Difference an ESG Ratings Provider Makes!” suggests the lack of consistency between ESG data providers’ methodologies means each can evaluate the same company differently, potentially leading to drastically different outcomes when these ratings are used to construct a portfolio.

That’s why financial advisors researching ESG investments need to do extensive due diligence with ESG raters.

“You actually need to look into the metrics they’re using, the attributes they’re interested in, and even to a degree, the weighting methodology to make sure metrics you care about are assigned a significant weight,” Li said.

Andrew Behar, CEO of As You Sow, a nonprofit shareholder advocacy group that has a website that reviews 3,000 funds on various ESG metrics, says ESG raters are hampered by a lack of standardization regarding how a company discloses ESG data—if they disclose anything at all.

“Right now, a lot of ESG raters are just looking at company websites and trying to figure something out,” he said. “And they’re all figuring it out a little differently.”

‘E’ Is More Standardized
Of the three ESG categories, Li notes their study shows the environmental category had the highest correlation between the two providers studied, whereas social and governance had lower correlations. Part of that reason stems from more environmental data being reported by companies because of pressure from investors and regulators, she explains.

Because of that, investors seeking highly rated environmental ETFs could have an easier time finding a fund that’s consistently highly ranked.

“I think there’ll be products offered that can closely satisfy your need,” she said. “But I’d say that due diligence is important so that you know exactly what they’re doing.”

 

 

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