24 Oct 2019

How MSCI rates companies for ESG

ESG Investing and Coronavirus
Florent deixonne

With the inexorable rise in demand for ESG investments, Lyxor ETF is bringing the latest thought leadership straight to investors. In this guest blog,Zoltán Nagy, Executive Director, Equity Core Research at MSCI,explains what kind of things MSCI looks out for when rating companies for sustainability.

Greater climate change awareness is supporting a strongly increasing trend in environmental, social and governance (ESG) investing. Investors have become much less tolerant of corporate ESG incidents and more willing to act because of them, creating a kind of virtuous circle. When investors take more notice of ESG events, those events may have a greater impact on financial performance, and this encourages more investors to take them seriously, starting the cycle again.

30 years ago, Exxon’s stock price barely moved when Exxon Valdez spilled 11mm gallons of oil on the Alaskan shore. It is hard to imagine that happening today, with social media allowing for immediate, global communication of issues. Investors are making companies accountable for their actions.

Supporting this shift is the vastly growing ESG data set, generated by a wide array of sources. Social media and self-disclosure policies, as well as work by NGOs and governmental organisations scrutinising company behaviour, creates large amounts of data that, when understood, can better inform the investment process. At MSCI, we have made significant investments in our ESG ratings capability to help institutions understand this data to make better investment decisions.

MSCI ESG ratings

MSCI ESG Ratings are designed to help investors understand ESG risks and opportunities and integrate these factors into their portfolio construction and management process. This is not just about environmental, social, and governmental risks, but how those factors relate to a company’s financial performance.

Our ESG research involves taking a huge data set and extracting the relevant information – then distilling the results into company, industry, and thematic reports, which can run to dozens of pages.

One aspect of our research is corporate controversies, which are a major component of ESG risk. MSCI ESG Controversies allow institutional investors to analyse a company’s impact by identifying involvement in major ESG controversies, adherence to international norms and principles, and assessing company performance with respect to these norms and principles. We categorise five major kinds of controversy: environmental, human rights and community impact, governance issues, customers, labour rights and supply chain. Our first priority is to assess the severity of a controversy: for example, would it cause death, or something less serious such as inflammation? Then we assess breadth: would this controversy affect a handful of people or millions?

Our analysis results in a final score between 0-10, usually represented in a traffic light system. This controversy score can be combined with our ESG score methodology. For the ESG score, first we evaluate all companies with regards to governance structures – how the board is structured, the executive pay, and so on – then select the most relevant environmental and social ESG risk factors relating to that company’s industry. For example, looking at soft-drinks company Coca-Cola, the key risks are: product carbon footprint, water stress, packaging material and waste, health and safety, and finally opportunities in nutrition and health.

Different ESG issues are significant for different industries. The financial industry suffers from far more bribery and ethical controversy than the utilities industry, for example, while the utilities industry is far more exposed to carbon emissions issues.

Finally, we combine the business activity data with geographic data to analyse risk exposure. What matters to us is risk exposure – not just disclosure – and how well a company is equipped to handle the risks we have identified. From this we create a “Leaders and Laggards” ranking, which is a peer-relative rating within industries, meaning in each industry you have AAAs, down to CCCs.

The financial value of ESG

There are three key transmission channels from ESG to financial value, according to our research: over a ten-year period, a higher ESG profile was associated with 1) profitability; 2) tail risk; and 3) systematic risk.

What is the framework for investors to access ESG in 2019? Historically the method was to align a portfolio with an investor’s ethical or political values, but the industry is now moving away from value-based screening (for example, an index that excludes fossil fuel) as a guideline. Nowadays, there is a growing focus on ‘targeted impact’ – meaning how to generate a measurable social or environmental impact, such as improving the environment or encouraging greater gender diversity.

MSCI’s ESG index family offers options for institutional investors with any ESG preference, whether they are looking to integrate ESG risks, meaning incorporating certain factors to enhance return; to invest with a values-based approach; or to target a specific impact.

Our “Select ESG Rating and Trend Leaders” indices are uniquely designed to target companies that have a robust ESG profile as well as a positive trend in improving that profile.

Zoltán Nagy, Executive Director, Equity Core Research at MSCI

The view from Lyxor

Rather than striving to achieve a specific impact, Lyxor’s ESG Leaders ETFs could appeal to those investors simply trying to “do something” with their money by making a broader, positive contribution to society. We partnered with MSCI, a leading expert in ESG data and scoring, to help identify those companies possessing a robust ESG profile. While our Europe ESG Leaders fund targets the ESG champions of today, our Trend Leaders funds go one step further by also rewarding companies who have successfully improved their ESG rating over the previous year.

Lyxor’s difference makers

This article is for informative purposes only and should not be taken as investment advice. Lyxor ETF does not in any way endorse or promote the companies mentioned in this article. The opinions expressed by Zoltán Nagy are his own, as at September 2019, and do not necessarily reflect the views of Lyxor International Asset Management or Societe Generale. Capital at risk. Please read our Risk Warning below.

Risk Warning

This document is for the exclusive use of investors acting on their own account and categorised either as “Eligible Counterparties” or “Professional Clients” within the meaning of Markets in Financial Instruments Directive 2014/65/EU. These products comply with the UCITS Directive (2009/65/EC). Société Générale and Lyxor International Asset Management (LIAM) recommend that investors read carefully the “investment risks” section of the product’s documentation (prospectus and KIID). The prospectus and KIID are available free of charge on www.lyxoretf.com, and upon request to client-services-etf@lyxor.com.

Except for the United-Kingdom, where this communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorized and regulated by the Financial Conduct Authority in the UK under Registration Number 435658, this communication is issued by Lyxor International Asset Management (LIAM), a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/EU) and AIFM (2011/61/EU) Directives. Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority).

The products mentioned are the object of market-making contracts, the purpose of which is to ensure the liquidity of the products on the London Stock Exchange, assuming normal market conditions and normally functioning computer systems. Units of a specific UCITS ETF managed by an asset manager and purchased on the secondary market cannot usually be sold directly back to the asset manager itself. Investors must buy and sell units on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units and may receive less than the current net asset value when selling them. Updated composition of the product’s investment portfolio is available on www.lyxoretf.com. In addition, the indicative net asset value is published on the Reuters and Bloomberg pages of the product, and might also be mentioned on the websites of the stock exchanges where the product is listed.

Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice. It is each investor’s responsibility to ascertain that it is authorised to subscribe, or invest into this product. This document is of a commercial nature and not of a regulatory nature. This material is of a commercial nature and not a regulatory nature. This document does not constitute an offer, or an invitation to make an offer, from Société Générale, Lyxor Asset Management (together with its affiliates, Lyxor AM) or any of their respective subsidiaries to purchase or sell the product referred to herein.

Research disclaimer

Lyxor International Asset Management (“LIAM”) or its employees may have or maintain business relationships with companies covered in its research reports. As a result, investors should be aware that LIAM and its employees may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see appendix at the end of this report for the analyst(s) certification(s), important disclosures and disclaimers. Alternatively, visit our global research disclosure website www.lyxoretf.com/compliance.

Conflicts of interest

This research contains the views, opinions and recommendations of Lyxor International Asset Management (“LIAM”) Cross Asset and ETF research analysts and/or strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental Cross Asset and ETF Research opinions and recommendations contained in Cross Asset and ETF Research sector or company research reports and from the views and opinions of other departments of LIAM and its affiliates. Lyxor Cross Asset and ETF research analysts and/or strategists routinely consult with LIAM sales and portfolio management personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of ETFs tracking equity, fixed income and commodity indices. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. Lyxor has mandatory research policies and procedures that are reasonably designed to (i) ensure that purported facts in research reports are based on reliable information and (ii) to prevent improper selective or tiered dissemination of research reports. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, competitive factors and LIAM’s total revenues including revenues from management fees and investment advisory fees and distribution fees.