This site is directed at UK Institutional/Professional Investors only. It is provided for information purposes only and should not be construed as investment advice nor a recommendation to buy/sell any products nor as an offer or solicitation to engage in any investment activity.

The role of Carbon in the Evolution of ESG Investing – Chapter 1

Why is there so much confusion about ESG investing?

ESG. SRI. Sustainable Investing. There are many different terms and acronyms used to describe the trend to include Environmental, Social and Governance indicators into investment decisions; they mean different things to different people, and investors all along the value chain. From the largest global managers right down to the end-investors in a pension fund, investors are confused – both in terms of the ESG impact of their money and the effects of ESG on the financial performance of their portfolio.

Even once a common understanding of nomenclature is achieved, there is little consensus on what this means for portfolios; what issues need to be addressed, how investors should go about implementing those into a portfolio, how to report back to an investor, and ultimately what it would mean for the investor’s portfolio and risk and return. Broad consensus does exist in Europe in the critical area of Climate Change, which is almost universally recognised as important from both ethical and financial perspectives.

This paper aims to summarise the current state of the market, potential ways forward, and why this matters for market participants to cover three main perspectives;  

  1. What are the main approaches to ESG investing and how should investors use the plethora of ESG data and ratings available to them? 
  2. Why is Climate so important for investors of all kinds?
  3. How has Low Carbon/Climate investing evolved over time and what new tools are available to develop the next iteration of solutions? 


It is not an exaggeration to suggest that ESG is an existential threat to some Asset and Wealth Managers, and it poses huge risks to Asset Owners. Indeed, we have already seen how this can affect companies. In August last year DWS shares fell more than 13% in a day following allegations of greenwashing1. In Australia, REST (a large Superannuation pension fund) was successfully sued by one of its members for failing to consider the impact of Climate Change2. 

As ESG adoption increases, becoming the “new market cap” in passive portfolios and a critical part of active portfolios, these risks will amplify. Failure to act now could risk missing the boat entirely, but a failure to properly embed and report on ESG issues could lead to accusations of greenwashing. However, ESG is also an opportunity. As research continues to explore the impact of ESG indicators on financial returns, there is the possibility for asset managers to deliver superior risk returns, and also to deliver portfolios more in line with investor expectations as society continues to shape opinions. For providers of investment solutions of all kinds, making the correct response to ESG and, in particular to Climate Change, may well be the difference between success and failure. 

What do ESG Ratings tell us?  

The first step to understanding ESG investing is to recognise the reality that there is more than one approach to considering ESG, and each is valid. For many people ESG investing is about aligning their investments with their values; for instance by holding less of companies that do things they don’t like, or holding more of companies that are having a positive impact. For others, it is a fiduciary question –what risks do ESG issues expose in my portfolio? For most, it is increasingly a combination of the two. In addition ESG investing covers a wide range of issues (see table below), and a company can be a leader in one area whilst a laggard in another.  

Table.1 Threats and opportunities within the ESG landscape

Source: SparkChange

This helps to explain why there is confusion around ESG ratings available in the marketplace. There are two main criticisms. 1) Correlations between different ESG ratings providers are often low, making it hard to know which data to trust and 2) products marketed as ESG may focus on financial metrics or still include stocks from sectors such as Oil & Gas.

According to a 2019 study by the Sloan School at MIT3, correlations between six of the leading ESG ratings was 61%. This is in sharp contrast to mainstream credit ratings where correlations between S&P and Moody’s were 99%! They identified three main reasons for the differences:

  • Core divergence occurs when ratings are based on different attributes,
  • Measurement divergence happens when agencies measure the same attributes, but do so using different raw data, and
  • Weights divergence — which emerges when ESG ratings agencies take different views on the relative importance of attributes.

It is certainly fair to consider whether the same criteria should be applied to every stock. Supply side labour rights is a bigger issue for Apple than Alphabet, data privacy is a bigger issue for both than for Chevron, and carbon emissions are more important for Chevron than JPMorgan. This can create an opportunity for managers, as they can consider whether to use the underlying data points in a more detailed way than a headline ESG rating. A rating is, by design, an amalgamation of a company’s approach and score on a wide range of ESG issues.  It is also fundamental for a manager to thoroughly understand how any ESG data or rating being purchased is constructed, and whether they agree with the approach to building that rating being taken. Like anything else, this is a case of rubbish in, rubbish out. If the methodology is flawed the results will also be flawed, and those results would not be expected to correlate with a superior product. We can illustrate this using an example of a well-known scandal.

In September 2015, the US Environmental Protection Agency announced that Volkswagen were found to have installed devices on eleven million cars designed to cheat on emissions tests. This was a huge global story that had two immediate impacts from an investment perspective: 1) many clients did not want to hold VW stock and 2) the stock price fell sharply. To address the former was very straightforward, although a well-designed process can also be used on less high profile and obvious examples. The second issue of the falling stock price is at first more problematic. VW Stock fell from a price of €162 per share on 18 September to €92 by 2 October. It didn’t return to its pre-crisis level for over two years, causing significant drag on any portfolios that held it at or above its index weight. The emissions scandal appeared to be an Environmental issue, but of course as nobody knew it was coming it was not picked up by ESG ratings agencies prior to the EPA announcement.

However, this does not mean there were no ESG indicators that could have helped investors before the scandal broke. Volkswagen was treated very differently by different ESG ratings providers in the period leading up to the EPA announcement. For some, VW were best-in-class for the automobile sector. They were vocal on sustainability issues, seemed to take investor concerns seriously, and it is certainly fair to say that wilful deceit is hard for analysts to pick up. But just as no self-respecting stock analyst would buy list a company based purely on what management tells them, neither should an ESG rating be based solely on company disclosures or the answers to a survey. As a Funds Europe article4 noted shortly after the scandal broke, there were governance concerns that were identified by both fund manager groups such as Hermes, and ESG ratings providers like MSCI. Both had noted falling governance scores in 2015, caused by concerns such as the lack of board diversity and a concentrated and complex ownership structure. This did not of course mean that they could or would have predicted the scandal or the resulting fall in the share price, but it did illustrate the need to consider corporate governance practices as part of evaluating a stock. It stands to reason that scandals are more likely to occur in companies with weaker cultures, less transparency and poor management oversight. For this reason, research suggests that Governance may have more predictive power in avoiding left tail risks from major ESG breaches. What at first sight may have appeared to be an Environmental scandal at VW may be better understood as an issue of governance.

The issue of what stocks should be in an ESG portfolio is a more basic misunderstanding that can only be resolved through clear marketing and communication. A recent article in Bloomberg5 took aim at MSCI, the world’s largest ESG research company, claiming an ‘ESG Mirage’ because their ratings are about financial risks of ESG and not the impact a corporation has on the world.

This raises three points;

  1. It is exactly how MSCI describe their own ratings, so clients can assess whether this is the right measure for them.
  2. Hundreds of underlying data points are available for an asset owner or manager to build their own score if they prefer a different approach. There is no one way to implement ESG beliefs into a portfolio - indeed, an ESG ratings system that simply puts all Oil & Gas producers on a low rating is not really providing an insight worth paying for. Business involvement data is available from a broad range of providers and allows managers to screen out certain sectors or companies based on their exposure to undesired business activities, either on an absolute basis or based on revenue thresholds. This approach is frequently taken by Asset Owners able to implement their own specific rules through mandates or Institutional products, and increasingly by passive managers in the fund and ETF markets.
  3. Companies are increasingly required by regulators to consider the ESG related financial risks in a portfolio – since October 2019 UK pension funds have been required to disclose in their Statement of Investment Principles (SIP) how they take account of "financially material considerations" of ESG and Climate Change.


In conclusion, to criticise ESG ratings for their lack of correlation or the stocks held by ESG products is to miss the point. Uniformity of ESG ratings may be theoretically desirable (market-efficiency-wise) as an end goal for investors, but it is at best, decades away. Uniformity would also remove what is an opportunity for today’s managers – to differentiate through ESG. Screening out companies or sectors is one part of designing ESG products, but the critical thing is for product manufacturers to clearly articulate what they are doing and why, and to ensure that matches the needs of the parts of the market they are targeting.

Attitudes are clearly evolving. In December 2019, The Economist bemoaned the ‘dismal’ science behind ESG ratings, saying “It does not matter what firms are selling, as long as it is done sustainably. Tobacco and alcohol companies feature near the top of many ESG rankings. And many funds marketed on their green credentials invest in Big Oil.”6. By January of this year, the same publication had concluded the opposite, saying “Funds with zero emissions would be virtuous, but those that cut their footprint fast might be even better.”7. This is a recognition that change on the scale required isn’t possible without changing the behaviour of the biggest emitters. This last point is a crucial one for addressing the biggest consideration of all for ESG investors – how to address the issue of Climate Change.

Common screening strategies

For many investors, the first toe in the water for ESG investing is to screen out some stocks or sectors based on a value judgement on what they don’t want to hold. Since this is simply a reduction in the investable opportunity set, it will reduce diversification and introduce tracking error in comparison to the parent index or portfolio before those screens. As a result, there needs to be a delicate balance between a client’s values and the impact on the risk and return of their investment. The right balance will depend on the client, but broad lessons can be learned from a review of the marketplace in EMEA. The two key variables when considering what the most common exclusions are for investors are geography and channel, although these overlap, so will be considered together

Within channel investing, the largest asset owners increasingly expect complete customisation. Many will have their own exclusion lists of stocks they do not want to invest in, produced from proprietary research or bought in from an ESG research house, and/or detailed screens that will take out stocks based on the businesses they are involved in. This level of bespoke delivery is made possible by the size of the allocations and the ability to deliver them through segregated mandates, but obviously add complexity and cost to support. There is of course some variation in what a typical Asset Owner will require based on geography. For instance, most Middle Eastern sovereigns and pension funds will want to exclude Israel, exclude sectors typically screened in Islamic investment such as alcohol, gambling and adult entertainment and have a more relaxed attitude to exposure to Oil & Gas. However, overall it makes sense to view these as individual clients and tailor their portfolios accordingly.

For slightly smaller Asset Owners accessing pooled product, there are clearer trends emerging. The most common pan-European exclusions are controversial weapons, severe controversies, and increasingly, thermal coal. The first and third of these are relatively static, but the controversies list will vary over time based on breaches of the UN Global Compact and other standards, and the remedial action companies take as a result. After that, the most common but by no means standard exclusions include tobacco and nuclear energy. As we shall explore later, there are bigger differences once you look beyond simple exclusions and look at approaches aiming to integrate ESG considerations into the investment process.

For public products the picture is more complex, and the regional differences are more pronounced. The most advanced markets are the Nordics and the Netherlands, where exclusions are part of mainstream investing and not just a separate option for investors. Most major Nordic Asset Managers have detailed sustainability or responsible investing policies that include screens applied to all portfolios, across both active and passive product and different asset classes. Some have been doing this for a very long time – for example, KLP in Norway have been applying screens to all portfolios since 2002. Even when they run index funds, most Nordic managers run what are referred to as ‘close to’ funds rather than a pure replication of the index, in order to maintain flexibility over what is screened out from the portfolio. This is driven by high levels of end investor awareness, engagement and expectations. Typically, an index will wait until the next rebalance (usually quarterly) to exclude a stock even after a major controversy, but Nordic managers are likely to get calls from clients straight away asking if the stock is in their portfolio. Applying the “close to” concept allows the manager to be more nimble, and address investor concerns straight away, thereby replicating the approach taken in their active products. One final step Nordic managers often take is to also look at integrating positive inclusion criteria and overweight green investments that are addressing the issues we highlighted above. This is not as universal as negative screening as it is not applied to all portfolios, but it is a logical step as ESG becomes more influential in investment decisions.

Adoption in the Netherlands has followed a similar path. NN are one of several managers who post an exclusion list on their website, telling investors which screens (of controversial weapons, controversies, tobacco, thermal coal and oil sands) they apply, and which stocks are excluded as a result. In addition, as with Nordic managers such as SEB, they have further exclusions for more focused ESG product ranges. It is also common to post a list of countries whose sovereign bond issues are not eligible for inclusion. These markets are ahead of the curve, but are an interesting case study for other managers who want to understand how ESG investing may evolve over time.

In the other main markets and the pan-European market, adoption has generally been slower. Excluding controversial weapons is a relatively common position but otherwise adopting ESG positions into all portfolios regardless of an ESG label is less common outside of smaller niche players. But the needle is definitely moving. BlackRock launched a range of market-cap ETFs with a consistent set of ‘house’ screens applied, in addition to their other ranges of higher conviction ESG products. These utilised quite extensive screens, covering Controversial and Nuclear Weapons, Civilian Firearms, Tobacco, Thermal Coal, Oil Sands and Controversies, a list almost as broad as the highest conviction ESG products in the iShares range – their SRI funds. Despite this, they were priced in line with existing market-cap products rather than as an ESG premium, suggesting they will be positioned as alternatives to a pure market-cap approach.

BlackRock are not the only ones - BNP Paribas also launched their entire ETF market-cap range as ex Controversial Weapons (it should be noted that investing in controversial weapons is illegal in France). The more concentrated, higher conviction products tend to have broader screens that may also cover topics like gambling, alcohol, adult entertainment and in some cases nuclear power or conventional weapons. The pace of adoption, and whether investors will skip a stage and move straight to fully integrated ESG solutions rather than use screened indexes as a stepping-stone isn’t clear today. But the direction of travel is – all managers will need to consider ESG issues, and be able to explain to investors why they have taken the approach they have.

Spark Change Group Limited (FRN 944451) is an Appointed Representative of Kroll Securities Ltd. (FRN 466588) which is authorised and regulated by the Financial Conduct Authority.

Communication Disclaimers
This communication has been provided to you for informational purposes only.

This communication is not intended to constitute, and should not be construed as, investment advice, financial promotion, investment recommendations or investment research.

This communication is not intended as and is not to be taken as an offer or solicitation with respect to the purchase or sale of any security or interest, nor does it constitute an offer or solicitation in any jurisdiction, including those in which such an offer or solicitation is not authorised or to any person to whom it is unlawful to make such a solicitation or offer. Distribution of information contained in this communication may be restricted by law. Persons receiving this communication should inform themselves about and observe any such restrictions. Any dissemination or other unauthorised use of this information or documents by any person or entity is strictly prohibited.
SparkChange believes the information in this communication to be correct at the date of issue. However, no representation or warranty is given as to the accuracy of any of the information provided. Some information in this communication is based on information given/obtained from independent research providers that SparkChange considers to be reliable. Analysis provided in this communication may be based on subjective assessments and assumptions and can use one among several alternative methodologies that produce diverse results. Hence, analysis and projections should not be seen as factual and should not be relied upon as accurate predictions of future performance.

Request Full PDF Report