ESG Investment: Growth and Integration

Introduction

• Every investment requires a benchmark for performance evaluation and improvement
• ESG ratings and indices are essential for reflecting vital business matters in company evaluations
• ESG ensures tracking against corporate benchmarks, making them actionable for investors
• Increased investor interest in ESG drives sustainable investment market growth and changes business practices

Growth of ESG Investment

• ESG investment has risen significantly, with global assets under management growing from US$4 trillion in 2006 to approximately US$60 trillion in June 2016
• This represents an annualized growth rate of 35%, according to the Principles for Responsible Investment (PRI)
• US-domiciled AUM of investors considering ESG factors reached US$8.72 trillion in 2016, a 33% increase from US$6.57 trillion in 2014
• From the first industry survey in 1995 to 2016, ESG investment increased almost 14 times, with a compound annual growth rate of 13.25%

Integrating ESG

• Investment strategies integrating ESG proactively factor in material considerations influencing firm valuation
• This includes corporate governance, gender equality, water scarcity, product safety, and climate change
• The demand for ESG-integrated investment has grown, prompting investors to improve evaluations of portfolio companies' ESG performance
• Stakeholders, like consumers and regulators, increasingly incorporate corporate sustainability performance into decision-making

ESG Metrics

• Companies are seeking external ESG metrics to measure and validate their ESG efforts, with some linking executive compensation to these metrics
• ESG ratings and indices have grown in quantity, quality, complexity, and variety
• 108 ESG ratings systems were tracked in 2010, up from 21 in 2000, and over 250 global and local ESG schemes were identified in 2013
• GISR offers a searchable database for corporate ESG ratings, tabulating 121 ESG indexes and 39 ESG ratings products globally
• MSCI operates over 700 ESG equity and fixed income indexes, while S&P Dow Jones specializes in over 50 headline daily indices with over $5 billion in AUM

Purpose of Chapter

• The importance of benchmarks for investments
• The aim is to give the general reader a basic grasp of the current state of ESG ratings and indices and their significance in investment and business value chains
• Definitions for ESG ratings and indices are provided
• Recent evolutions in the ESG ratings and index marketplace are described
• Four leading ESG ratings providers (MSCI, S&P Dow Jones, FTSE Russell, and Thomson Reuters (now Refinitiv)) and their significant ESG index products (e.g., MSCI ACWI ESG Index, Dow Jones Sustainability World Index, FTSE4Good Global Index, and the Thomson Reuters ESG Indexes for US Large Cap stocks and Developed Markets) are profiled.

ESG Index Construction

• The chapter discusses the best practices as well as limitations of the current ESG ratings and index practices
• Despite advancements in coverage, rigor, and reliability, challenges persist in the ESG ratings and ESG indexes space

Three Main Challenges in ESG Ratings and Indexes

• Dynamic Nature: ESG ratings and indexes are constantly changing and expanding, resulting in comparability issues for long-term users
• Lack of Agreement: Absence of settled agreement in academia and practice about the precise definitions of ESG and its measurement
• Unclear Link: The need for a clear, positive link between portfolio valuation and ESG
• Impact of ESG Ratings and Indexes: Examines the impact on investors, corporations, and their managers
• Approaches to Incorporating ESG: Different approaches taken by investors, including shareholder activism, thematic investing, impact investing, and ESG integration in valuation and portfolio analysis are reviewed

Corporate Managers and ESG

• Corporate managers face growing pressure to incorporate ESG, increasing interaction with ESG activist investors, regulators, consumers, and employees
• Corporate managers are adapting attitudes towards ESG and seeking 'win-win' outcomes for shareholders and other stakeholders
• Chapter Organization: Section 2 defines ESG ratings and indexes, Section 3 describes recent developments, Section 4 profiles major players
• The chapter describes one representative index from each major ESG index provider, Section 5 discusses best practices and pros and cons of ESG ratings methodologies

Section 6 and 7 of the Text

• Expands on three main challenges and opportunities in ESG ratings and indexes
• Examines the impact of ESG ratings and indexes on investors, corporations, and corporate managers
• Section 8 offers the conclusion of the text

ESG Ratings and Indexing

• The term 'index' has various uses, such as a list, rating, or ranking, with indexes serving as crucial infrastructure for investors tracking performance
• S&P Dow Jones Indices LLC manages over 1,000,000 indexes covering a wide range of asset classes globally
• Indices imply an investable strategy, but this is not always the case
• ESG ratings involve a scoring framework to evaluate performance on ESG factors systematically, yielding a combined ESG score
• They apply to various organizations, from public equity to real estate
• ESG index describes an investable index, usually market capitalization-weighted, aggregating company scores assessed for ESG

Benchmarking

• The investment market requires benchmarks to evaluate ESG strategies, quantify financial impact, define portfolio characteristics, and identify risk
• Weighting individual company constituents may vary depending on investor preference, including tilting based on ESG attributes
• ESG ratings firms may calculate and market their own indexes or partner with index vendors
• ESG indices applications: establishing performance benchmarks and support passive investment strategies using derivative instruments
• Serving as investment universes for active managers
• Indexes used by companies as benchmarks, media framing company merits, and stakeholders

Influence of the ESG Index

• The actual size of investment tracking DJSI is modest, dwarfed by other investment strategies and the market capitalization of the 3400 companies in its research universe
• The ESG index designer has great latitude in creating the architecture of an ESG index
• Issue-weighted indices are generated companies based on an issue
• Existing groups of companies design an ESG index by re-ranking or re-weighting based on ESG factors
• ESG eligibility are based on research and ratings
• The ESG investing value chain illustrates the relationship between ESG research, ESG ratings, and ESG indexes

ESG Ratings Market

• The ESG ratings market has changed over the past two decades from small NGOs, economic development groups, specialist firms, and consultants
• Industry aggregation led to industry majors with more research staff, distribution platforms, capabilities, and client diversity
• A significant driver was MSCI's acquisition of RiskMetrics Group in 2010, which had acquired Innovest Strategic Value Advisors and Kinder, Lydenberg, and Domini Research & Analytics
• MSCI also acquired GovernanceMetrics International
• Sustainalytics expanded through acquisitions and merged with Jantzi Research
• Vigeo Eiris was formed by a merger of EIRIS and Vigeo
• ISS was sold off and acquired Ethix and IW Financial

Factors Driving Consolidation in ESG Ratings Market

• Scale and profitability
• ESG stakeholders diverse and evolving demands
• Data availability to increase from technology
• Demand and more portfolio companies in different countries push ESG data coverage
• Major ESG ratings and/or indexes firms include Oekom, Sustainalytics, Inrate, RepRisk, FTSE, Trucost, MSCI ESG, S&P Dow Jones, and Thomson Reuters
• Proliferation of ratings as ESG issues get more nuanced and complex, raise profile, and ratings getting global interest

ESG Index Providers

• ESG indexes are value-added products developed by ESG ratings companies, tracking investment portfolios
• The Domini 400 Social Index is the first and longest-running index, launched in 1990, tracking companies using ESG criteria
• KLD Research & Analytics Inc. (now MSCI) created as an alternative to the S&P 500 index, benchmarking a cohort of US-listed companies
• Variety of firms provide these products for use as benchmarks, investment universes, or to license as investment portfolio trackers, including financial services firms, sustainable investment firms, ESG research firms, and stock exchanges

Role of ESG Index Providers

• Recognized for research staff and index offerings
• Having global ratings coverage and product distribution
• Plays a de facto regulatory role in the ESG ratings market
• It is strategically significant for the investment ecosystem
• Used as a dominant reference point for investors

MSCI

• Based in New York, MSCI Inc. is a research-based indexes and analytics provider
• Established in 1986
• Approximately $10 trillion in assets were benchmarked to MSCI indexes as of June 2015
• MSCI is a leading ESG index provider, offering over 700 ESG indexes equity and fixed income
• ETFs inflows to ESG equity indexes linked were around US$194 million from January to September 2015
• Only major index provider with in-house ESG research expertise through MSCI ESG Research Inc.

S&P Dow Jones and RobecoSAM

• SAM and Dow Jones Indices partnered in 1998 to launch the Dow Jones Sustainability Index (DJSI) as a global sustainability benchmark
• Strategic union of sustainability theme to partner with the reach major index firm
• SAM provided ratings of ESG and rankings, DJ with index distribution and mechanics
• SAM founded in 1995, focusing entirely on sustainability investing
• In June 2016, RobecoSAM managed equity funds around USD 10.8 bn
• S&P Indices and Dow Jones Indices joined

FTSE Russell

• FTSE Russell is wholly-owned by London Stock Exchange Group (LSEG)
• LSEG describes itself as diversified infrastructure and capital markets business
• In 2011, LSEG gained remaining FTSE equities by selling
• In 2014, LSEG had bought Russell Investments to participate efficiently and effectively with MSCI, S&P Dow Jones
• FTSE had about US$4 trillion of equities while Russell had about US$5.2 trillion
• FTSE Russell product provides benchmarks daily over 700

Government Mandate and FTSE4Good

• In 2000, the UK government started needing that funds state amount they take into ethical, social, and investment decision environmental impacts
• In 2001, FTSE released the FTSE4Good indices to solve growth
• According to research analyst Lipper, the launched and helped drive sustainable
• Is in the mainstream

Thomson Reuters

• Based in New York
• Provides news and information for professionals
• In 2009 acquired ASSET4, in Switzerland
• Founder in 2003 to integrate non-financial and difficult quantitative issues
• The Reuters Corporate Responsibility Indices (TRCRI)
• The goal to create financial ASSET4 universe consists with approximately 10000 securities

The TRCRI

• This analysis showed S-Network Global Indexes, a based specialist
• Founded proprietary indexes, and indexes
• Offering assets under The S-Network Global Indexes, work by Thomson Reuters