SPECIAL REPORT: SHARE INDICES
THE ESG RIDDLE
The clamour for fixed rules, definitions and processes within global financial services is arguably at odds with the rising prominence of ESG.
One might expect that certain characteristics make a company score high or low when establishing their ESG qualities.
But judging by the ESG indices of the largest providers, such as MSCI, S&P Global and Sustainalytics, subjectivity still plays a major role in defining ESG benchmarks.
Research by MIT in 2019 shows an average correlation among the six largest ESG rating agencies of 0.61 – well below the 0.99 correlation between the credit ratings of Moody’s and Standard & Poor’s.
The International Organization of Securities Commissions (IOSCO) has called for oversight of ESG ratings and data product providers. The International Financial Reporting Standards (IFRS) Foundation, which seeks to develop high-quality, understandable, enforceable, and globally accepted accounting and sustainability disclosure standards, has also weighed in. In 2021, it set up the International Sustainability Standards Board (ISSB) to meet investor demand on ESG.
Lee Clements, head of sustainable investment solutions at FTSE Russell, says there are now multiple regulations mandating enhanced disclosure of the ESG outcomes of indices, particularly those which claim to have sustainable characteristics.
Furthermore, while many index
providers produce factsheets to denote what an index includes, Scott Klimo, chief investment officer at Saturna Capital, says in a CISI webinar, ‘Active and index investing’, that “index construction is often opaque”. He highlights how different seemingly
similar indices can be, and that the choice of one over another could lead to
Active and index investing Our webinar on CISI TV discusses an approach to active investing, and how to construct portfolios with a Shariah screening process.
cisi.org/active- index
“But if you look at the investment market, through to corporations and on to client solutions, there is a need for more disclosure,” he says.
“Just 10% of companies in the Russell 2000 actually publish carbon emissions, so the inconsistency and lack of correlation in indices comes from the fact that the data is not disclosed at the starting point.”
He added there was a drive to ensure transparency around how data is transferred into ESG scores that link to inclusion in an ESG index, as well as better disclosure of data around whether an ESG-skewed index performs better on a sustainable/responsible basis (such as lower carbon emissions) than the parent index it is derived from.
The enhanced EU’s Sustainable Finance Disclosure Regulations, in effect since 1 January 2023, represent another hurdle that financial market participants, including index providers, will have to navigate.
But the focus on transparency and data seems preferable for many in the index world, as opposed to there being a rigid regulatory framework about what an ESG investment is.
Gareth Parker, chief indexing officer at Morningstar, says: “In principle, Morningstar feels that there are legitimate differences of opinion on ESG and legitimate differences about what ESG should be, and we feel as long as we create properly built, well-governed indexes then it’s appropriate for there to be different indices for investors to choose.”
unexpectedly high exposures to certain geographies, suggesting that active management could be advantageous for investors who wish to more closely manage their country weightings. “In the MSCI All-Countries World
index, the top five countries are the US, Japan, China, the UK and Canada, but the MSCI ACW Islamic index has the US, and then Switzerland in second place making up 10% of the index even though it isn’t even in the top ten of the conventional index. “So you might not necessarily have the
type of country exposure that makes sense for you.” Countries have made significant efforts
to gain inclusion in market indices. Kuwait, for example, in 2017 began on
the road towards upgrading from frontier to emerging market in the MSCI index. Its Market Development Project “brought numerous regulatory and operational enhancements to the Kuwaiti equity
CISI.ORG/REVIEW
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