Unravelling the maze of ESG indices

When the FTSE4Good stock market indices for environmental, social and governance (ESG) investors launched 20 years ago, the Daily Telegraph created a fictional ‘FTSE4Bad,’ comprising tobacco, gun and armaments stocks which produced a much more favourable return. How things have changed. The joke now about indices for measuring ESG performance is that, if you want a better rating, all you need do is change your rating provider.

According to the SustainAbility consultancy, more than 600 different ESG ratings and ranking existed in 2018. BlackRock, the world’s largest asset manager with nearly $9 trillion of assets under management, states that there are now more than 1,000.

Sarah Wilson chief executive of Minerva Analytics, which develops ESG voting support tools for active shareholders, reckons that of the total universe of 5,500 stock indices, perhaps as many as 3,500 rank as ESG. For corporates and investors alike, that makes for an extremely confusing galaxy.

Year zero in this context was 31 years ago. Before 1990, there was not a single recognised ESG index on the planet. Then came Morgan Stanley’s MSCI KLD 400, followed nine years later by the first global index, the Dow Jones Sustainability Index.

MSCI, now separate from the Wall Street bank, claims to operate 1,500 different ESG indices. A kind of premier league may be emerging, containing ESG indices run by other major recognisable names, such as Deutsche Bourse, Thomson Reuters and Bloomberg, but there are literally thousands of others, all with different criteria. Seeking to register one’s ethical credentials in a suitable index resembles an ungainly alphabet soup.

One of the challenges is that they use different algorithms, so the answers they produce can be quite varied, with the same organisation appearing quite high on one and quite low on another

Wilson even expects the number of ESG indices to grow further. ‘The days when countries had one stock exchange and a national air carrier are long gone,’ she says. ‘Stock exchanges nowadays make more money from licensing and selling data than they do from selling listings.

‘I would expect the number of ESG indices to only increase from this point. Companies are no longer measured on whether they can get into the FTSE 100 index. There are a whole load of other requirements for companies now and ESG ratings and indices are the best way of measuring and tracking where they are with them in a comparable way.’

Few dispute that, with the growth of index investing generally over the last decade and an increasing recognition that companies need to be measured on what they do to the world as well as how much money they make from it, there is a demand for recognised ESG indices.

Rather, the questions are about scope, scale and accessibility. Does the ESG movement need one or a small number of standard bearers, like has happened with global accountancy standards in recent years? Will the sector be weakened if such a winnowing does not occur? Or, with such a wide range of definitions of what constitutes progressive environmental, social and corporate governance, does the current increasingly plural system succeed in serving all?

For Robert Nuttall, partner at communications consultancy Fortitude Partners, there is definitely a vast surplus of ESG indices. ‘What we hear from corporates who are struggling to deal with this and have to respond to quite a few of these is that there are way too many,’ he says.

‘There are some that seem to be floating in the water, while others come up quite frequently. There are clearly some that are gaining higher profiles than others but one of the challenges is that they use different algorithms, so the answers they produce can be quite varied, with the same organisation appearing quite high on one and quite low on another. What are investors to conclude from all of that?

‘I imagine there will be a consolidation coming through because it’s very fragmented and there’s also a multiplicity of frameworks for standards, which is another challenge coming from this increasing focus on ESG.’

Nuttall admits that, with some many ESG indices to deal with, his agency does not focus on any in particular when it comes to advising clients. ‘It’s hard for corporates to decide which ones they should join in with or not,’ he says, because they all produce results that investors might be looking at and they don’t know which ones investors look at more than others.

‘It’s probably quite difficult for investors too. It’s all quite nascent at the moment. There’s been an explosion of activity and it’s making it all very hard to judge. AS this area matures, I imagine it will settle down much more.’

ESG is tracked back to a judgment really and it’s a subjective one because there’s no standardisation.

Kelly Perry, director of environmental, social and corporate governance at independent investment research, investor relations and consulting firm Edison Group, says: ‘There has been enormous growth in ESG indices. MSCI alone has around 1,500. It has really mushroomed.

‘Indices serve a purpose and are very helpful for investors. In terms of ESG-focused indices, there’s been a lot of rebranding of old indices, which to some degree has been helpful as well. Do we need as many?  No. Probably not, to be frank.

‘When advising corporates and investors, I actually steer away from them a little bit because there’s so subjective. Traditionally, indices have measured objective data such as stock market capitalisation, operating styles and other things tracked back to financial metrics. But ESG is tracked back to a judgment really and it’s a subjective one because there’s no standardisation.

‘There’s a hunger for standardisation because otherwise you get exactly what’s happening now, with probably in excess of 3,000 ESG indices out there. From a consumer investor’s perspective, where do they go? Where do they turn and which directions make the most sense for them and for businesses?

‘What’s happened is that interest in ESG data has surged. Investors have realised that ESG areas can have a material impact and businesses are seeking to drive their value in ESG portfolios. We’re seeing an awakening. But the lack of standardisation does make it very difficult for us to advise.’

Standardisation of ESG is a subject that’s dividing this new sector. ‘Nobody is ever happy with a standard,’ Bob Eccles, professor of sustainability at Oxford University’s Said Business School, told the Financial Times in a recent interview. ‘It’s a giant compromise. What you have with accounting is a social construct and an agreed-upon definition of reality that we all start from. That’s where we’re at with ESG.’

However, Eccles adds that if ESG information gets put on a par with other financial information, with the same quality of control systems, assurance, rigour and enforcement, that would be a ‘game-changer’ for the whole way that people invest in it.

With this kind of ‘holy grail’ at stake, it’s easy to see why those in the sector are getting excited. Wilson, whose company’s parent group markets its own ESG indices, believes the current situation is only the beginning and that focusing on the number of indices is the wrong approach.

‘Most people think of an index, they think of the FTSE 100 or the Dow Jones Industrial Average or the S&P500 but that’s really an old paradigm now,’ she says. ‘Exchange-traded funds have taken a leaf out of the old investment trusts handbook and created thousands of indices and funds around them with specific criteria. This is how low-cost investing works nowadays.’

Indeed, there are now thematic ESG funds focused on hydrogen or on decarbonised stocks deemed to have low risk to climate change. There’s also an ESG index that tracks investments that are friendly to the LGBTQ+ community.

Wilson says it’s possible to find an ESG index that doesn’t include makers of guns and bombs but is happy to include alcohol or an index of companies with more than 30 per cent of board seats occupied by women. The many ESG indices that are already available, she argues, are creating virtual supermarkets of ESG indices, tailored to whatever investors care about.

‘There are lots of different measures,’ she says. ‘You can have indices of Sharia funds and ESG with lots of different flavours. That’s all fine. These things can all be screened in or out with research. There are different strategies for different user cases and Investors don’t have to use one of the big names. It’s all regulated.

‘The European regulations are a bit ahead of the UK at the moment, with the Sustainable Finance Regulations seeking to define labels to avoid greenwashing. But there’s no longer such a thing as the index or the market. The market is much more atomised than people realise.

‘Just having one monolithic index that’s, saym market-capitalisation-weighted, is actually problematic. When people tell me they want a premium listing so their company can get into the FTSE 100, I just say Big deal. Maybe there are other indices that are more important.’

There is still much to unfold in the ESG indices space. Earlier this year, rules came into effect in Europe making financial firms and investors disclose their ‘double materiality’ – covering the risk that their operations pose to society as well as to their profitability.

Since September last year, five leading independent standard-setters having been working on creating a comprehensive corporate ESG reporting system. Meanwhile, the IFRS Foundation plans to launch a global Sustainability Standards Board at the United Nations’ COP26 climate summit in Glasgow in November.

Corporates are just going to have to go with the flow, keep a very close eye on what all the governance codes are and make sure that they meet the highest common denominator standards

Valerie Keller, the former EY director who co-founded Imagine, an organisation working to achieve systems change and build companies’ sustainability, with former Unilever chief executive Paul Polman, believes ESG indices are a useful mechanism to help investors vote with their cash for the achievement of the United Nations’ Sustainable Development Goals. However, she does believe that change is necessary.

‘We need all humans and businesses to focus on reversing climate change and the alarming extinction of biodiversity and widening inequalities,’ she says. ‘So we do need these indices to create systems change at scale and at speed, but there needs to be wider recognition of the merits of and necessity for each.

‘Humanity has been freed from American economist Milton Friedman’s restrictive monetarism doctrine that saw shareholder value as the single all-important metric with which to measure. Now the ESG metrics need to catch up.’

Wilson insists that corporates and investors should remain focused on the greater picture. ‘What boards should be thinking about is are they conforming to the highest standards of sustainability, climate change mitigation and risk management,’ she says.

‘Yes, there are a lot of different frameworks and there’s no one-size-fits-all definition of what’s good. But corporates are just going to have to go with the flow, keep a very close eye on what all the governance codes are and make sure that they meet the highest common denominator standards. It’s less about qualifying for a certain index and much more about what your individual investors care about.’