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ESG: Managing indices to match convictions

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More and more investors know it is perfectly possible to link index management with responsible investment by choosing an index fund or an exchange-traded fund (ETF). Index management can offer numerous ESG solutions in line with their convictions. 

The 2016 review published by the Global Sustainable Investment Alliance estimates worldwide sustainable investment volumes at approximately $23trn (€19.6trn). European investors contribute around $12trn to this. 

The concepts frequently encountered in this specific segment should be clarified: SRI stands for socially responsible investment. The European professional organisation, Eurosif, has broadened this concept to include sustainable and responsible investment. ESG stands for environmental, social and governance. Companies that are eligible for sustainable equity investments demonstrate a particularly high level of responsibility with respect to ESG criteria. 

In the past decade, an increasing number of institutional investors have been implementing their vision of sustainable investment by incorporating key criteria that take account of economic challenges, such as data on climate protection, in their equity analysis and portfolio management. This approach can constitute an ‘engagement’ basis for active shareholders, enabling these large-scale investors to contribute to making the economy more responsible. Many have turned to dedicated index mandates or funds that integrate their own ESG requirements (including a number of sector exclusions, for example). Those investments constitute the core of their allocations. Other key elements, besides the customising of the ESG approach and exclusions, include the voting rights policy and the set-up of the asset manager in this respect. 

We now see more and more private banks and retail networks asking for ESG index solutions. Some groups have already defined their minimum requirements in terms of exclusions and choice of allocation in relation to ESG criteria. Others have not and are looking for more clarity and for standardisation of ESG benchmarks. The minimum requirement is often based on the exclusion of companies or sectors if they breach certain ethical standards. Exclusions are often combined with ESG selection criteria based on ratings issued by the extra-financial research team on individual companies. 

The concept of best-in-class, for example, which is the most commonly discussed, describes a selection process whereby, within a given sector, the companies selected are those that offer the best environmental and/or social performance, and that have a high-quality management team. 

SRI indices 

As an initial step, SRI indices generally exclude the investment universe of companies active in the alcohol, gambling, tobacco, weapons, firearms, pornography, genetically modified organisms, thermal coal and nuclear sectors. Next, they add all companies with an appropriate ESG rating, size and sector of activity. The best-in-class approach favours companies that are rated the highest within their sector from an extra-financial viewpoint. 

Lastly, minimum standards are applied to the rating that is attributed following research on controversial themes through analysis and monitoring of controversial issues, such as breaches of the international standards set out by the United Nations or non-governmental organisations. 

The objective of controversy criteria is to reduce reputational risk. The themes concerned are the environment, human rights, workers’ rights, monitoring the supply chain and corporate governance. The investment universe for the MSCI KLD 400 Social index is the MSCI USA IMI, which is currently made up of 2,442 stocks. The MSCI KLD 400 Social index selects around 400 stocks according to the defined rules and adapts its composition every quarter. 

In addition to giving investors a clear conscience, what contribution can sustainable investment indices make? A critical function of the rules for building the index is to avoid economic risks for investors by rapidly identifying companies that do not pass the selection process. The scandals surrounding “dieselgate” and the Deepwater Horizon oil platform were decisive tests of ESG ratings. Volkswagen and BP1 were not represented in the corresponding indices before these controversies; they were not considered to be truly sustainable companies. In any event, the costs linked to the lawsuits and liability for environmental damage amounted to around $90bn for BP. For VW, the total costs of financial damages linked to the diesel emissions scandal has not been fully calculated. Up until now, they have amounted to $27bn in the US alone.2 

When finance acts for the planet 

Sustainable thematic index funds or ETFs can focus on one specific selection criterion, such as CO2 emissions, for example. The Low Carbon 100 Europe index, launched 10 years ago, represents an entirely sustainable thematic concept, which selects companies with a low carbon footprint. The index is composed of 100 European companies selected using the following process. 

Among the 1,000 largest European companies, 12 ‘green companies’ from the alternative energy, power, electronics, construction and industrials sectors that generate at least 50% of their sales in technologies with low carbon emissions are selected every year. Companies with controversial trade practices, manufacturers of controversial weapons and tobacco are excluded, as are companies in the defence sector. The 88 other companies in the index are selected from among the 300 largest companies on the basis of their environmental policy. The rankings established by CDP (formerly the Carbon Disclosure Project) or Carbone 4 (consulting firms specialising in climate data) have an influence both on the selection and the weighting of the shares in the index. 

The objective of the methodology is to limit the global warming scenario to 2°C. The index used data such as the Carbon Impact Analytics (CIA) rating of Carbone 4. This rating is comprehensive because it includes indirect carbon emissions and avoided emissions (recycling, biofuels, etc). In addition, it goes beyond merely measuring the carbon footprint because it also assesses the company’s contribution to energy transition, particularly through R&D efforts. 

This allows companies to take the long view of their strategies in terms of energy transition. The methodology also separates the investment universe into two sub-categories. On the one hand, companies highly exposed to the energy transition issue (so-called ‘high stakes’ companies) are selected based on their CIA rating; on the other, those whose business activities have a limited impact on global warming (‘low stakes’) are selected based on their CDP data. 

This index has a two-fold objective: to lower the weight of the stocks of companies that emit greenhouse gases and to support those that contribute the most to fighting global warming. For these companies, at least 50% of their business must come from ‘low carbon’ technologies (for example, renewable energies).

Isabelle Bourcier is head of quantitative and index management at BNP Paribas Asset Management 

1 The above-mentioned securities are for illustrative purpose only, are not intended as solicitation of the purchase of such securities, and does not constitute any investment advice or recommendation. 

2 Sources: www.n-tv.de, 9 September 2018; www.faz.net, 10 September 2018.

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