Deconstructing ESG Scores: How to Invest with your own Criteria?

IMF Working Papers, March 10, 2023

Source details

Canonical URL: Deconstructing ESG Scores: How to Invest with your own Criteria?

Environmental, Social, and Governance (ESG) scores amalgamate a broad range of fundamentally different factors, creating ambiguity for investors about the underlying drivers of higher or lower ESG scores.
The paper explores the feasibility and performance of more targeted investment strategies based on specific ESG categories by deconstructing ESG scores into their granular components.

Investigate the characteristics of the various categories underlying ESG scores to assess which types lend themselves to focused strategies.
Consider an exclusion-based investment scheme that removes firms with the lowest scores in a given category of interest.
Implement a “best-in-class” strategy by excluding firms with the lowest category scores and reinvesting the proceeds in firms with the highest scores while maintaining the same regional and sectoral composition.

Not all types of ESG categories lend themselves to more focused strategies, a limitation related to:
- limits to ESG data disclosure, and
- the fundamental challenge of translating qualitative characteristics into quantitative measures.
Excluding firms with the lowest scores in a given category:
- in most cases allows investors to substantially improve the ESG category score, and
- has a marginal impact on financial performance relative to a broad stock market benchmark.
- results in regional and sectoral biases relative to the benchmark, which may be undesirable for some investors.
The “best-in-class” strategy:
- reduces the tracking error of the portfolio,
- slightly improves risk-adjusted performance, and
- still yields a large gain in the targeted ESG category score.

Negative screening (exclusion of firms with the lowest category scores):
- Substantial improvement in the targeted ESG category score.
- Marginal impact on financial performance relative to a broad stock market benchmark.
- Induces regional and sectoral biases relative to the benchmark.
Best-in-class (exclude lowest scores; reinvest in highest scores while maintaining regional and sectoral composition):
- Reduces tracking error.
- Slightly improves risk-adjusted performance.
- Preserves large gains in the targeted ESG category score.

Deconstructing ESG scores helps design more targeted strategies aligned with investor priorities.
Trade-offs to consider:
- Improvement in specific ESG category scores versus induced regional and sectoral biases.
- Data disclosure limits and difficulties in quantifying qualitative ESG characteristics constrain the applicability of focused strategies.
A best-in-class reinvestment approach can mitigate some of the tracking error and composition biases of simple exclusion strategies while preserving ESG gains.

Torsten Ehlers, Ulrike Elsenhuber, Kumar Jegarasasingam, Eric Jondeau. March 10, 2023.