ESG Screening
- Jenna Jones (Unlicensed)
Scientific Portfolio's environmental, social and governance (ESG) investment framework is based on a double materiality approach. This involves managing both the financial risks induced by ESG criteria and the impact of a portfolio on sustainable development. ESG screening is viewed as the first step in analyzing a portfolio's extra-financial impact and building a more sustainable portfolio.
While mindful of the attempts made by some regulators to define what a "sustainable investment" is (see for instance Article 2 (17) of EU’s Sustainable Finance Disclosure Regulation), we propose to return to the historical origins of the concept of sustainable development to design a consistent and practical framework for sustainable investors.
The seminal 1987 Brundtland report provided a definition of sustainable development that is still in use today: a development that “[…] meets the needs of the present without compromising the ability of future generations to meet their own needs.” However, the concept was already known in the 18th century [1]. Carl von Carlowitz, who oversaw the silver mining operations in Saxony (Germany) under the reign of King Frederick Augustus I, used the word “sustainability” in 1713 when he recommended stopping the overexploitation of forests, which he saw at the time as a risk to the wood supply chain. A few decades later, in the spring of 1789, Thomas Jefferson suggested to his friend Lafayette that he add an article specifically dedicated to the “rights of future generations” in what was to become (a few months later) the French Declaration of the Rights of Man and of the Citizen. Although there is evidence that Lafayette did submit the article, it was not included in the final draft... Jefferson, who was the US ambassador to Paris at the time, clarified his views on the matter in a letter sent to James Madison a few months later:
“The question whether one generation of men has a right to bind another, seems never to have been started either on this or our side of the water. Yet it is a question of such consequences as not only to merit decision, but place also, among the fundamental principles of every government. […] I set out on this ground, which I suppose to be self evident, “that the earth belongs in usufruct to the living”: that the dead have neither powers nor rights over it […] Then no man can, by natural right, oblige the lands he occupied, or the persons who succeed him in that occupation, to the payment of debts contracted by him.” (6 September 1789)
While Carlowitz’s motivations were primarily economic and Jefferson’s were undoubtedly political and philosophical, both shared the idea that sustainability was, in their minds at least, first and foremost about protecting the world, not necessarily improving it.
The original and historical definition of sustainable development was therefore much closer to a do no harm (DNH) injunction, possibly a very strict one, than a call to action to do good and change the world. The nature of the “harm” should be clarified in practice, and the United Nations’ 17 Sustainable Development Goals (SDGs) provide a framework for identifying the environmental and social goods that ought to be protected.
Today, exclusions are carried out for various reasons, including ethical principles, risk management, or influence on companies. The “influence” argument suggests that exclusions increase the cost of capital of excluded companies, incentivizing them to change their behavior. While the argument is reasonable, it is important to note that from an academic perspective, establishing the presence of a link between exclusion and extra-financial impact remains a challenge. Scientific Portfolio closely monitors developments in this area to incorporate new and useful academic ideas into its platform.
Scientific Portfolio ESG Screening functionality
The DNH essence of sustainability makes ESG screening and exclusion policies a natural lever for ESG investors. They are expected to play a central role in the design of sustainable investment portfolios. To this end, the Scientific Portfolio platform uses screening policies (exclusion criteria) to analyze the negative impacts (if any) of a portfolio on the United Nations’ 17 sustainable development goals (SDGs).
The SDG framework is made up of 17 goals, 169 targets and 254 variables. These goals were originally designed for governments to guide their policies and actions towards sustainable development. However, it has become clear that companies also have an important role to play in achieving these goals. Scientific Portfolio has therefore carried out a granular analysis to determine how companies may also have a negative impact on each individual goal and its corresponding targets.
The first step is to determine whether a specific SDG target concerns companies, and if so, to ensure that companies can have a negative contribution to the target. We remove targets from our scope where companies cannot make a significant positive or negative contribution. Once this list of business relevant targets is determined, we systematically map business activities or behavior that might have a negative impact on SDG targets. We also link these business activities or behaviors to "issues", which correspond to the industry's ESG traditional screening terminology. In this way, our framework allows us to analyze companies that have a negative contribution to sustainable development from the perspective of issues or from the perspective of sustainable development targets and goals. Note that the link between an issue and an SDG target may be « certain » or « uncertain » depending on the underlying ESG data available. For example, when screening the SP USA CW Benchmark using the Consensus screen and setting the “Certainty Impact Only” filter to False, one company is identified as having a negative impact on SDG 5: Gender Equality; however, if the “Certainty Impact Only” filter is set to True, this particular company is not counted. The reason is that the company is flagged for Discrimination Controversy, an issue that might not solely manifest itself through gender, making its impact uncertain. In the Screen Details table, however, the company is always categorized under “contribute negatively” since the issue Discrimination falls within the scope the selected screen.
In practice, while exclusion strategies remain popular, there has generally been no consensus on the criteria used for exclusion. In order to assist investors, our platform offers three pre-built ESG screens, which each correspond to a possible exclusion policy:
The Sustainable Development Goals screen highlights any company whose behaviors and activities undermine the achievement of one or more of the SDGs. We thus find criteria that concern a wide variety of sectors on different social, environmental or governance issues and that allow us to cover nearly all SDGs.
The Consensus screen is based on a set of criteria derived from an analysis of the exclusion policies of the 100 largest global asset owners. This analysis has resulted in the selection of the four most common exclusion criteria: involvement in tobacco, coal, controversial weapons, and controversies related to the UN Global Compact. The exclusion criteria is as follows:
- Firms with revenues related to the Controversial Weapons industry.
- Firms with revenues related to the Tobacco industry.
- Firms that have more than 5% of the revenues related to the Coal industry.
- Firms that present United Nations Global Compact (UNGC) principles violation-related controversies with a non-minor severity.
The Paris Alignment Benchmark screen highlights companies that are not compatible with the Paris Agreement goals according to the EU climate transition and Paris-aligned benchmarks delegated regulation. The Commission Delegated Regulation (EU) 2020/1818 supplementing Regulation (EU) 2016/1011 of the European Parliament and of the Council defines minimum standards for the PAB, and some of these concern exclusions. We consider this regulation as a basis for defining the PAB screen which includes the following exclusion criteria:
- Firms that have more than 1% of revenues related to the Coal industry.
- Firms that have more than 10% of revenues related to the Oil industry.
- Firms that have more than 50% of revenues related to the Gas industry.
- Firms with revenues related to the Controversial Weapons industry.
- Firms with revenues related to the Tobacco industry.
- Firms that benchmark administrators find in violation of the United Nations Global Compact (UNGC) principles or the Organization for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises.
The set of variables and their thresholds are dependent on the given screen.
ESG data is a complex area and therefore, data is not always widely available for every target or for every company with respect to every issue. For instance, there may be targets where companies can have a direct negative impact; however, there may not be sufficient data to measure a company's contribution and therefore, the target is currently not considered. As a result, each screen is built based on the data that is publicly available and therefore may slightly deviate from the screen objective. Additionally, there are some instances where we are not able to determine whether or not a company contributes negatively to one or more goals due to a lack of available data for that specific company. In such cases, the number of companies for which data is missing or incomplete is identified and classified as ‘Missing’ within the screen details on the Scientific Portfolio platform.
References
1 H. Berkowitz and H. Dumez. (2014). La double origine du developpement durable: Carl von Carlowitz et Thomas Jefferson. Le Libellio d'Aegis. 10(1): 17-20.