ESG CLARITY in association with MSCI presents the
Breaking Down ESG Ratings Series
A series of comprehensive briefings on ESG ratings, other key ESG and climate data and how they can be put into practice by fund selectors. Each theme includes a Q&A video and a downloadable pdf document for more detailed information and insights
ESG ratings – how do they work and what do they tell you?
With Rumi Mahmood
01 | EXPLAINER
With Marine Durrieu
02 | portfolios
How wealth managers can use ESG and climate data
With Abbey Schmitt
03 | clients
Talking to clients about ESG and climate
With Fotios Kassianidis
04 | outcomes
The signal to noise ratio - what ESG data actually matters?
The rise of ESG ratings
Despite the huge rise in interest over the past number of years, it was actually back in the 1960s that the concept of ESG investing was born in the form of Socially Responsible Investing (SRI).
Using a series of screens to exclude companies or entire sectors based on certain business activities - such as tobacco production or involvement with South Africa’s apartheid regime - investors were left with a portfolio of companies that were seen as more socially acceptable. In the 60 years that have followed, responsible investing has evolved hugely and so has the data we have available to screen companies, says Rumi Mahmood, ESG & climate fund researcher at MSCI. As investors globally increasingly adopt ESG considerations into their processes, Mahmood says ESG ratings have emerged with the primary aim to assess company’s long-term resilience to financially material ESG risks. At its most basic level, Mahmood says the MSCI ESG Rating is designed to assess a company’s long-term resilience to financially material, environmental, social and governance risks. “We apply a rules-based methodology to identify the leaders and laggards across industries based on their exposure to key ESG risks and opportunities, and how well they manage these versus their peers,” he says. The end result is that companies are rated on a AAA to CCC scale, relative to their industry peers.
‘We apply a rules-based methodology to identify the leaders and laggards across industries based on their exposure to key ESG risks and opportunities, and how well they manage these versus their peers’
“The MSCI ESG Ratings model focuses on key risks and opportunities that are material for any given sector,” Mahmood says. “We have over 450 analysts analysts globally who look at 35+ key ESG issues across sectors, looking at the intersection of a company’s core business activity and the industry-specific risks and opportunities that apply.” To fully understand how the ratings vary from sector to sector, Mahmood points to how MSCI rates technology companies, which would not be typically perceived as directly impacting the environment. “If we look Amazon or Facebook, their main operations are more tech-focused than operating an oil field where there are clear environmental risks,” Mahmood says. “As a result the environmental pillar, or the weight of its impact in the ESG rating, would be less relative to a utility company or energy firm, which operates in an environmentally strained area.” However, he adds there are other factors at play which would be more financially material for technology firms, such as data privacy or how well they are aligned with regulations or governance factors. “Those factors would carry more weight relative to environmental ones in this case,” Mahmood says. At the same time, he says that in the ratings process MSCI does not prescribe judgements on any given company or sector. “We are aware that certain sectors are more pollutive, such as energy and utilities, but they still form a part of investors’ portfolios and they still have a role to play in the energy transition,” he says. “We rank companies intra-sector so investors can assess which companies are better in managing financially material ESG risk relative to their peers, and make an informed decision.” Aware that many investors do care about more than just financial factors, Mahmood says MSCI does have additional metrics to allow for a more nuanced approach factoring in values alignment and positive impact. “We have additional data points to show what a company’s business involvements are such as exposure to controversial weapons or UN Global Compact violations,” he says. “On top of this, some investors may care more about positive screening through the degree of investment in, or financing in, sustainable activities,” he adds. “To this extent, we have data points that show the revenue exposure to the development of sustainable solutions, or the revenue exposure to clean technology, which allows investors to form more positive assessments in terms of what companies are directly financing.” MSCI has a public ESG Ratings & Climate search tool which allows investors to search over 2,900 companies, all of which are constituents of the MSCI ACWI Index. “You can search by company name or ticker to view the Implied Temperature Rise, Decarbonisation Target, ESG Rating, the ESG Rating history, the ESG rating distribution by industry, industry-specific ESG Key Issues and how the company compares with its industry peers,” says Mahmood.
‘We rank companies intra-sector so investors can assess which companies are better in managing financially material ESG risk relative to their peers, and make an informed decision’
Having rated the underlying stocks and bonds, the final step of the journey is the ESG ratings of the funds themselves, so how are these arrived at? “In the first step we take the weighted average ESG score of a fund’s underlying holdings,” says Mahmood. “We then assess the degree to which a fund is exposed to companies that are exhibiting an improving ESG rating, versus a worsening ESG rating. Finally, we look at the fund’s aggregate ESG tail risk, measured by the level of exposure to companies that are ESG laggards, rated B to CCC.” Combining all these factors, ultimately Mahmood says the fund’s ESG rating provides the aggregate measure of the portfolio holdings’ resilience to long term financially material ESG risks.
The information contained herein (the “Information”) may not be reproduced or redisseminated in whole or in part without prior written permission from MSCI ESG Research. The Information may not be used to verify or correct other data, to create any derivative works, to create indexes, risk models, or analytics, or in connection with issuing, offering, sponsoring, managing or marketing any securities, portfolios, financial products or other investment vehicles. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. MSCI ESG Research is provided by MSCI Inc.’s subsidiary, MSCI ESG Research LLC, a Registered Investment Adviser under the Investment Advisers Act of 1940. MSCI ESG Research materials, including materials utilized in any MSCI ESG Indexes or other products, have not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. None of the Information or MSCI index or other product or service constitutes an offer to buy or sell, or a promotion or recommendation of, any security, financial instrument or product or trading strategy. Further, none of the Information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The Information is provided “as is” and the user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. NONE OF MSCI INC. OR ANY OF ITS SUBSIDIARIES OR ITS OR THEIR DIRECT OR INDIRECT SUPPLIERS OR ANY THIRD PARTY INVOLVED IN THE MAKING OR COMPILING OF THE INFORMATION (EACH, AN “INFORMATION PROVIDER”) MAKES ANY WARRANTIES OR REPRESENTATIONS AND, TO THE MAXIMUM EXTENT PERMITTED BY LAW, EACH INFORMATION PROVIDER HEREBY EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES, INCLUDING WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE. WITHOUT LIMITING ANY OF THE FOREGOING AND TO THE MAXIMUM EXTENT PERMITTED BY LAW, IN NO EVENT SHALL ANY OF THE INFORMATION PROVIDERS HAVE ANY LIABILITY REGARDING ANY OF THE INFORMATION FOR ANY DIRECT, INDIRECT, SPECIAL, PUNITIVE, CONSEQUENTIAL (INCLUDING LOST PROFITS) OR ANY OTHER DAMAGES EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES. The foregoing shall not exclude or limit any liability that may not by applicable law be excluded or limited. Privacy notice: For information about how MSCI collects and uses personal data, please refer to our Privacy Notice at https://www.msci.com/privacy-pledge.
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Database ESG Ratings & Climate Search Tool
Reports ESG & Climate Funds in Focus
Video 2022 ESG Trends to Watch
Infographic Inside MSCI ESG Ratings: How are companies scored?
Download the PDF
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So how do the MSCI ESG Ratings work?
Looking beyond financial materiality
Fund ratings
Find out more
Contact us
For more information on MSCI’s ESG and Climate Research, Data or Tools please get in touch at esgleads@msci.com
Studies conducted in 2019 showed that 89% of millennials expected their financial professional to do a deep dive into a company’s ESG factors and history with ESG issues before recommending an investment opportunity.
In the three years that have followed, the demand for ESG and climate-change funds has soared alongside the number of funds available to investors. Driven by a desire to better reflect and report on ESG-related investment views and values, MSCI ESG Research has responded to a growing demand among wealth and asset managers for greater investment transparency. “There are many ways investment managers can integrate ESG within their portfolios, but first and foremost they need to set their strategy and decide which ratings they want to target specifically,” says Marine Durrieu, an ESG consultant at MSCI. MSCI ESG Fund Ratings make it possible to rank or screen mutual funds on a AAA (leader) to CCC (laggard) ratings scale. In total the ratings leverage MSCI ESG Ratings for over 8,500 companies (approximately 14,000 total issuers including subsidiaries) and more than 680,000 equity and fixed income securities globally to create ESG scores and metric for some 53,000 multi-asset class mutual funds and ETFs. Durrieu notes it is common practice by many wealth managers to exclude any CCC or B-rated funds because they do not typically align with their ESG mandate. “After establishing a minimum threshold of ESG ratings for the underlying holdings, wealth managers can add additional screening layers focusing on impact and business involvement in order to align with their values” adds Durrieu. In addition to allowing for the screening of funds to align with client values, Durrieu says the ESG fund ratings are also designed to be used by wealth managers seeking to offer full reporting on the ESG characteristics of their client’s investments and measure ESG characteristics and sustainability impacts arising from investments. “MSCI provides automated reports that are an overview of the ESG assessment of the fund,” she says. “It’s all very easy, a wealth manager adds a portfolio and a benchmark they want to assess it against and get a PDF report. This provides the ESG rating of the fund, a breakdown of the leaders and laggards within the portfolio but also an overview of the carbon risk and sustainable impact that clients are increasingly interested in.”
‘After establishing a minimum threshold of ESG ratings for the underlying holdings, wealth managers can add additional screening layers focusing on impact and business involvement in order to align with their values’
Report Illuminating the Relationship Between ESG and Performance
Video Climate Exposure and Its Impact on a Client’s Portfolio
Blog What Implied Temperature Rise Means for Funds
Infographic UN Sustainable Development Goals: How do companies stack up?
So how can wealth managers integrate ESG and climate data into their own offerings?
Deep dive into risks and opportunities
Source: MSCI Portfolio Extended Summary Report using a sample portfolio benchmarked against MSCI ACWI as of July 14, 2022.
MSCI also licenses more than 200 additional metrics which are designed to offer greater insights into the ESG characteristics of funds, as well as provide additional information with respect to ESG fund research, product selection, portfolio construction and portfolio reporting across asset classes. “MSCI’s data can help inform investors on the environmental or social impact funds and issuers hold. Providing revenue exposure of companies or funds from environmental impact, such as climate change (eg energy efficiency, green buildings) and social impact such as basic needs, empowerment (eg education and SME financing). “Alternatively they may prefer to focus on the United Nation’s Sustainable Development Goals (SDGs). With a climate focus, an investor may want to target strong alignment with SDG13 ‘Climate Action’, while also excluding certain criteria such as any revenue exposure to fossil fuel or coal.”
1 Allianz ESG Investor Sentiment Survey conducted in 2019. 2 As at July 2022.
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Although these data are aggregated to provide a fund-level view, they are also available at the issuer level. If wealth managers then want to drill down even further beyond just looking at the ESG Fund-level information, Durrieu says MSCI does offer a full report on specific issuer level ESG ratings. “The ESG issuer ratings can provide a deep dive into the ESG risks and opportunities that an issuer is facing and how this issuer is managing those risks compared to their peers,” she says. “The reports can be leveraged to provide further insights for better investment decisions but also for engagement purposes.”
How can clients measure the impact of their portfolio?
Over the past two years, ESG funds have seen an enormous rise in fund flows. With individual investors increasingly looking to incorporate their sustainability preferences into their investments.
03 | CLIENTS
One of the biggest driving forces behind this demand has been climate change and the desire to fund solutions that can mitigate it and help on the race to net zero. “Climate is a very up-and-coming topic in the investing world,” says Abbey Schmitt, former ESG and climate investing consultant for MSCI. “People are realising that climate is a risk that impacts investments across asset classes and geographies. Advisers need to ask their clients if they want to take climate risk into account when thinking about portfolio construction. On the flip side, advisers can ask their clients if they want their portfolios to contribute the least possible emissions to global warming.” The problem, however, as with both the ‘S’ (society) and ‘G’ (governance) of ESG, is how to approach the topic of climate change with clients and how to make it tangible? “If clients are interested in integrating climate change considerations in their investment process, a great starting point is just looking at carbon emissions,” says Schmitt. “So, how much emissions does your portfolio emit versus the benchmark and is your portfolio aligned to target reducing its emissions over time?” For Schmitt, carbon emissions can sometimes seem intangible and hard to quantify in your head, so the key question is what does it actually mean? “A lot of our wealth clients and advisers are using carbon emission equivalents such as cars taken off the road, trees planted and gallons of gasoline used to make the reductions in emissions more meaningful and really bring the climate story to life,” she says. “We are seeing lots of advisers and wealth management firms integrate these more tangible reporting metrics in their client investment overviews and investment proposals.” After looking at carbon emissions, Schmitt believes there are two sides to the climate coin. First, what is the enterprise value at risk of a client’s investments from global warming, and second, how their companies and funds are aligned with global temperature goals. “For the first scenario we have a metric called MSCI Climate Value-at-Risk (VaR), which helps quantify the potential impact,” she says. “On the other side of the coin there are many different metrics to look at. Are there chances that my funds contributing to global warming beyond their fair share and are there chances that they going to push us past the tipping point of no return? Or are they aligned with the Paris Agreement target of staying below 1.5-2C of warming from pre-industrial levels by 2100 in order to maintain a relatively habitable world for us and future generations?” For clients at the beginning of their ESG investing journey, Schmitt argues carbon emissions are an easier place to start, and then maybe moving into what at MSCI they term the Implied Temperature Rise (ITR) metric. “It’s a pretty easy signal to say my fund or portfolio is 2 degrees aligned versus 10 degrees,” she says.
‘People are realising that climate is a risk that impacts investments across asset classes and geographies’
Guide ESG & Climate Guide for Financial Advisers
Blog Personalizing Climate-Focused Wealth Management Portfolios
Infographic Top 5 Sustainable Investing Questions Advisers Need Answered
Infographic How Differentiated ESG & Risk Insights Lead to Stronger Portfolios
Making data tangible
Starting the ESG conversation with clients
But should clients be exposed to data at all? With so many different data points in which to try and measure ESG factors, is it really helpful for clients, who themselves may have strong views and attitudes to both the environment and other ethical considerations? “Exposure to ESG data, including ESG fund ratings, really does depend on your clients’ goals and objectives,” says Schmitt. “Advisers either proactively expose them to ESG and explain that it is a new risk which is important to take account of within their investment portfolio, or they can use it as a response when asked about environmental, social or governance topics. “There are lots of different data points, and while ESG fund ratings are just the tip of the iceberg, they are a great place to start,” she adds. With ESG risks increasing and set to impact financial returns, there is also the question of how advisers should broach those clients who have yet to bring up the issue of ESG within their portfolios. “Given that some aspects of ESG can be political, some people might think it tough to bring up in certain client situations,” says Schmitt. “I think a way to mitigate this is to potentially focus on the financial risk/return aspect and make it quantitative.” For example, when discussing all the other risks to a client’s portfolio, Schmitt says an adviser can discuss how ESG could potentially protect on the downside in times of market volatility, or potentially outperform on the upside.
Climate VaR provides a stressed market valuation of a security in relation to aggregated transition and physical cost and profit projections until the end of the century. Implied temperature rise from MSCI ESG Research is an intuitive, forward-looking metric, expressed in degrees Celsius, designed to show the temperature alignment of companies, portfolios and funds with global temperature goals. ESG aspects do not guarantee returns or outperformance.
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For clients less concerned with the financial risks associated with ESG issues and who simply don’t want to invest in companies damaging the planet, or those considered less ethical such as gambling and weapons, Schmitt says there are options available. “Historically, value investing, or what we call negative screening, was the most popular strategy that was made available by wealth management firms for ESG,” she says. “So many firms have funds that exclude fossil fuels or weapons etc, or are aligned with religious values. “These types of strategies are good for clients who don’t really want to have an active hand in proactively addressing some kind of ESG or impact theme,” she adds. “These strategies are really about aligning with personal preferences.” The type of strategy that has become more popular in recent years, however, she adds, are those which adopt an ESG financial risk/return focus. “We see a number of wealth management firms expanding their sustainable investing toolkit, and incorporating ESG ratings, climate and SDG data, and showing it to those clients who prefer to look at myriad factors alongside traditional financial risk/return analysis,” Schmitt says. ESG ratings do take climate risks into account but do not go as in depth as other climate metrics. To discover the wide breadth of metrics available visit our ESG Ratings & Climate corporate search tool, which allows you to search for data such as implied temperature rise, decarbonisation targets and MSCI ESG ratings for more than 2,900 companies.
Alternative metrics
“Of course, this is very dependent on the type of ESG product and the time, but advisers can look at all those normal quantitative metrics they would have in a normal investment conversation and then bring in ESG,” she adds. While not originally designed as an investment framework, one area wealth managers consistently point to in ESG conversations is the UN Sustainable Development Goals (UN SDGs). So what is Schmitt’s advice on how these should be used, could they be a possible red herring? “The UN SDG’s are great to look at when an adviser’s client has an impact lens, or if they are trying to do some form of thematic investing that aligns with healthcare or food and agriculture for example,” she says. “We do have the data available that can classify a company or a fund as being aligned with one of the UN SDGs, so it can be a helpful metric if you have a client looking to drive progress in that area.” In addition to SDG alignment data, MSCI also provides underlying data on company and fund revenue exposures to environmental or social impact products and services. While the UN SDGs are also great to look at in terms of alignment, if a client’s objective is purely financial Schmitt notes they may not be as relevant to the conversation. “In that case an adviser might want to focus on the overall fund ESG rating, which is designed to measure the resilience of mutual funds and ETFs to financially material ESG risks” she says.
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