French consultancy Scientific Beta has examined the potential trade-off between investments with high ESG scores and lower carbon emissions.
- Because ESG scores and carbon intensity are unrelated, they are difficult to simultaneously achieve for investors.
- The growth of ESG and climate investing has led the industry to promote strategies that aim to fulfil both higher ESG scores and lower carbon emissions.
- According to the researchers, implementing exclusions based on ESG criteria and then focussing on climate scores when defining portfolio weights avoids green dilution.
The growth of ESG and climate investing has led the industry to promote strategies that aim to fulfil both higher ESG scores and lower carbon emissions. According to a new report by French consultancy Scientific Beta, the potential trade-off between these two dimensions has been overlooked.
Researchers quantified this trade-off by measuring global equity portfolios’ carbon intensity rise, which is caused by adding ESG score objectives to a low carbon intensity objective. They accounted for heterogeneity in ESG preferences by relying on 25 ESG theme scores from three major ESG rating providers – MSCI, Refinitiv and Moody’s – and building portfolios based on numerous combinations of ESG objectives and carbon reduction.
By comparing the greenness of portfolios intended to have both higher ESG scores and lower carbon intensity to that of portfolios solely built to reduce carbon intensity, the researchers computed the incremental impact of the inclusion of ESG scores on carbon intensity reduction, which they called ‘green dilution’.
How common is green dilution?
Green dilution is pervasive – regardless of which ESG scores are targeted as objectives – substantial, with an average of 92% across the portfolios in the analysis, and robust across several alternative specifications. A 92% green dilution means that 92% of the carbon intensity reduction investors could have reached by solely weighting stocks to minimise carbon intensity is lost, when adding ESG scores as a partial weight determinant. Only 8% of the carbon reduction objective survived the inclusion of ESG scores in portfolio weighting schemes.
Adding a single ESG score in portfolio construction, so that stock weights are equally determined by carbon intensity and the ESG score in question, leads to a green dilution of 65% on average. Mixing ESG scores that are expected to be green, and belonging to the environmental pillar, with carbon intensity also leads to a substantial deterioration in green performance.
Mixing scores from the social or governance pillars with carbon intensity routinely results in portfolios that are less green than the cap-weighted index: on average, social and governance scores more than completely reversed the carbon reduction objective.
Why is this happening?
The cross-sectional rank correlation between ESG scores and carbon intensity is close to zero. Because the two objectives are unrelated, they are difficult to simultaneously achieve for investors.
Scientific Beta said that this low correlation explains ESG and carbon scores should not be mixed in portfolio weighting schemes. A more sensible alternative is to separate the two objectives, by first screening out stocks with low ESG scores, and then weighting the remaining stocks by the investor’s key objective, carbon intensity in our case.
Since both dimensions are unrelated, screening out stocks by ESG scores does not affect the carbon intensity distribution of the stock universe. As such, ESG exclusions result in a neutral impact on portfolio carbon intensity, with a green dilution close to zero.
A spokesperson for Refinitiv says: “While very small, the correlation found in this study isn’t surprising, especially in developed markets, where many large organisations – with focused sustainability strategies, underpinned by strong Governance, higher awareness of their societal impact and robust disclosure – will perform well based on ESG scores, in spite of the fact that many will also overweight on carbon.”
A spokesperson from MSCI ESG Research notes that, in the Environmental pillar, MSCI ESG Ratings looks not only at a company’s past carbon emissions, but also at its plans to curb emissions in the future, its investments to seize opportunities related to clean technology, and its management of biodiversity- and nature-related risks.
“As different sectors are exposed to different ESG risks, MSCI follows an industry-specific approach focused on giving more weight to the material risks and opportunities for each sector of the economy. As a result, the relative weight of each key issue within a company’s rating will be determined by its industry,” the spokesperson adds.
“For example, carbon emissions that are financially material for carbon-intensive industries, such as oil and gas, but are less important for industries like banking, where the biggest climate risk lies in what they finance, are weighted more heavily in the model than their own emissions.”
What should investors do?
Scientific Beta said that the quantitative mixing of ESG and carbon scores in equity portfolio weighting schemes comes at a great carbon cost for green investors. Conversely, the exclusionary approach to ESG objectives would accommodate multiple non-financial and unrelated objectives.
The green dilution can be avoided through a separation approach, where ESG scores are used only for screening while weights are solely determined by carbon metrics. This conclusion arises from the fact that ESG ratings and carbon intensity metrics are unrelated to each other, according to the researchers.
MSCI ESG Research stresses that it “works closely with clients to provide the appropriate information and products to inform their investment decisions”.
Sustainable investments are attracting huge amounts of capital – for example, global sustainable bond issuance has the potential to eclipse the initial 2023 forecast of $950 billion despite challenging markets, according to Moody’s research. Scientific Beta’s findings underline the complexity behind ESG investing and the need to exercise caution when it comes to labels, as well as the importance of having a clear investing strategy in mind.