Global asset manager Russell Investments has created a material environmental, social & governance (ESG) score, which it says more accurately identifies ESG factors that could impact the financial performance of publicly-traded companies.
The research findings have been released in a paper entitled ‘Materiality Matters: Targeting ESG issues that impact performance’. The paper presents research that these material ESG scores are better predictors of stock return compared to traditional, non-material ESG scores.
“Our new material metric allows ESG investors to differentiate between companies in a more precise way than a traditional ESG score,” says Scott Bennett, director, equity strategy and research, at Russell Investments and an author of the research paper. “We can now distinguish those companies which score highly on ESG issues that are financially material to their business and profitability.”
Bennett adds that the relevance of ESG issues varies industry to industry and company by company, undercutting the effectiveness of a one-size-fits-all ESG scoring system. For example, fuel efficiency has a bigger impact on the bottom line of an airline than an investment bank.
“We have found that traditional ESG scores are composed of many issues that are not material to the business being scored,” Bennett says. “Using a diverse market sample in the Russell Global Large Cap Index universe, we found that less than 25 per cent of the data items in the traditional ESG score are considered material for two-thirds of all securities in the index.”
To create the new scoring methodology, the research team began with comprehensive ESG scores from data provider Sustainalytics—which are used for a wide variety of reasons beyond investment selection—and the industry-level materiality map developed by the Sustainability Accounting Standards Board.
“Our material scores are positively correlated to traditional scores, but they are meaningfully different,” Bennett saays. “We now have research which indicates that investing in companies based on high material ESG factors is significantly better than those with greater immaterial factor.”
The team back-tested the new scores between December 2012 and June 2017, using the Russell Global Large Cap Index, and found that a firm’s material ESG score offers a promising signal for informing investment decisions. Investors who selected Russell Global Large Cap Index stocks with higher material ESG scores could potentially have gained an additional 22 basis points compared to using the traditional ESG scores.
Bennett adds that these illustrative results align with expectations of industry bodies such as the Task Force on Climate-related Financial Disclosures and the United-Nations backed Principles for Responsible Investment that actively recommend companies focus more on the material ESG issues that directly affect their bottom line.
The early results also have encouraged Russell Investments to incorporate the new material ESG scoring approach into its current decarbonisation strategy, which serves as the foundation for low carbon investment funds available in several markets globally.
Lisa Schneider, managing director, non-profits and health care systems, at Russell Investments, says: “This new material ESG scoring approach advances the industry’s understanding of ESG performance drivers, and I’m happy we can deliver this thought leadership to our clients.”