Sustainable and climate friendly investing: At the expense of returns?

Elias Noschis31.08.2021

Sustainable investing is gaining momentum. But how can you invest in a sustainable and decarbonised future without impairing your returns?

According to Victor Hugo, no army can resist the power of an idea whose time has come. Sustainable investing is on its way there. For decades, scientists and activists have been warning about climate change and its consequences. These voices have increasingly gained acceptance in recent years. Financial markets have also taken notice. CNBC published in April 2021 that sustainable investing is the most sought-after sector of the financial industry. Growth has been swift: sustainable investments worldwide hit $1,000 billion for the first time in the spring of 2020, and this amount roughly doubled a year later.

But what is sustainable investing? The focus is on environmental, social and governance (ESG) criteria. These metrics aim at making the ethical and sustainable behaviour of individual companies comparable and assessable. In addition to the usual financial indicators, investors are increasingly considering such ESG criteria. Several specialised rating agencies are currently evaluating listed companies according to ESG criteria. Well-known agencies include MSCI, Sustainalytics, RobecoSAM, and Bloomberg ESG.

MSCI, a financial data agency, compiles various indices for the sustainable finance industry. Let's take a closer look at three indices for illustrative purposes: MSCI ESG, MSCI SRI, and MSCI SRI Reduced Fossil. The procedure for creating these indices is always the same: it starts with a long list of companies such as the 500 largest listed companies in the USA or in Europe. Depending on the index, different selection criteria are applied in a specific order. Of the three indices, MSCI ESG includes the most companies, while MSCI SRI Reduced Fossil has the least. The table below illustrates which selected US companies are included in which indices.

The ESG selection method

For the indices MSCI ESG and MSCI SRI, the selection method consists of three steps. Firstly, companies generating more than 5%-10% of total sales in controversial business areas are excluded. These include industries such as tobacco, weapons, nuclear energy, thermal coal power or the unconventional extraction of crude oil and natural gas. In the second step, companies with particularly controversial business practices are excluded. Each company is rated with a score from 0 to 10. Companies with a score of zero are excluded from the index. This happened to Volkswagen in 2015 following the manipulation of emission data of some of their diesel cars. In the third step, MSCI evaluates various sub-criteria in each of the environmental, social and governance categories. This results in a final rating at MSCI, with AAA being the best and CCC being the worst. In the MSCI ESG index, the best 50% companies by market capitalisation are then selected for each industry sector and per region; in the MSCI SRI index, it is the top 25%. This filtering of companies has the following effects in the case of the US stock market: as of August 2021, there are 625 companies in the MSCI USA index. For the MSCI ESG, this figure is 289 (46% of MSCI USA) and for the MSCI SRI it is 154 (25% of MSCI USA). The companies Procter & Gamble and Starbucks (both included in the MSCI ESG) are excluded from the MSCI SRI because they do not belong to the best 25% companies within their industry.

As the name suggests, another step is added to the MSCI SRI Reduced Fossil index. Eliminated are companies that generate more than 5% in total sales by extracting, manufacturing, producing energy from or having reserves of fossil fuels. Around 20 further companies are excluded by this filtering step. The MSCI SRI Reduced Fossil thereby contains 135 companies in the USA (22% of MSCI USA). Among the excluded companies is Centerpoint Energy, an electricity and gas network operator.

The world of sustainable finance can already show successes. Big oil companies like Exxon Mobil or Chevron Texaco have been excluded from capital inflows from the sustainable investment universe. As a result, the pressure on such companies to improve the sustainability of their strategy is growing. Until recently, it would have been inconceivable that board members driving sustainability would join Exxon Mobil's board of directors. In fact, this happened in the spring of 2021 under pressure from an activist hedge fund. But on closer inspection, classifying companies into “good” and “bad” ones is not always easy.

Scope for improvement of ESG ratings

A broad consensus on the best ESG selection methodology has not yet emerged. Firstly, some criticise the business sectors classified as controversial. Nuclear power is currently excluded from sustainable investments, while oil or natural gas power is included in some sustainable funds. This is difficult to reconcile with the desired reduction in CO2 emissions, or even the goal of zero emissions. Secondly, various rating agencies assess individual companies differently. Workday Inc. published a more detailed ESG report in 2015 than in the preceding years. Following this report, Bloomberg upgraded its environmental and social ratings for Workday; MSCI raised its social rating, but downgraded its environmental rating; at Sustainalytics, the rating for the environmental metric remained unchanged, whereas the rating for the social metric improved.

This year, State Street Global Advisors conducted a systematic comparison of the four ESG rating agencies mentioned earlier. The correlation - a measure of overlap - between agencies is between 48% and 76%. For comparison: the correlation between credit ratings of different rating agencies (S&P, Moody’s, Fitch etc.) of companies is 99%.

The third point of criticism is directed at the quality of ESG data. The rating agencies usually determine their ESG ratings based on self-disclosed information by the companies. Unlike financial metrics, companies' ESG reports are not audited by independent auditors. Since the segment of sustainable finance is only just emerging, there are no broadly recognised and standardised ESG key figures.

At True Wealth we offer a choice of two investment strategies, an unconstrainted global portfolio and a sustainable global portfolio. In the sustainable portfolio, we invest in Exchange Traded Funds (ETF) which follow the “greenest” indices, that is we choose indices with the strictest ESG and carbon emissions criteria where feasible. We selected the market leader MSCI because of its broad acceptance within the sustainable finance industry. For US investments, we use the MSCI SRI Reduced Fossil and MSCI SRI Low Carbon Select indexes. Over the past five years, investments in the sustainable indices have yielded returns in line with the broadly diversified index such as the MSCI USA (see below).

For the strictest alternative - the MSCI SRI Reduced Fossil - returns can deviate from the standard index by a few percentage points annually. The reason for this is that the energy sector is underrepresented in this index. The health care sector is currently overrepresented. This resulted in higher returns in 2020 and lower returns so far in 2021. We don't want to prescribe to our customers whether to invest sustainably or not. We believe that both approaches can be justified. This view is reflected in our fee structure. Irrespectively of whether you settle for the sustainable or the unconstrained portfolio, our annual fee of 0.25% - 0.5% remains unchanged. In addition, providers charge around 0.2% annually for global and around 0.3% for sustainable ETFs. This fee gap has been narrowing in recent years and can be partly explained by the growing capital flows into sustainable ETFs.

Conclusion

Innovations within the financial industry are making it possible for informed investors to invest their money on attractive terms in the stock market. If the trend of the last 5-10 years carries on and capital keeps flowing into sustainable investments, companies will be under increasing pressure to operate sustainably. If you select a sustainable portfolio at True Wealth, you are investing in the most sustainable companies with a particular focus on reducing carbon emissions. Investors in sustainable investments are thus rewarded twice: they contribute to an environmentally friendlier future whilst earning a return with broadly diversified exposure in line with the market.

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Disclaimer: We have taken great care with the content of this article. Nevertheless, we cannot exclude the possibility of errors. The validity of the content is limited to the time of publication.

About the author

author
Elias Noschis

Editor at True Wealth. Elias holds a Ph.D. in physics and studied at ETH Zurich. He holds an MBA in International Business Management. After having worked in Switzerland's watch making industry, Elias has published books on investing for a broader audience.

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