New research reveals that the effectiveness of targeting low carbon emissions in equity portfolios can be almost entirely wiped out when putting a large emphasis on other ESG considerations.
A new study from global index provider and research house Scientific Beta, Green Dilution: How ESG Scores Conflict with Climate Investing[1], provides clear evidence of the dangers for investors of mixing ESG and carbon scores in equity portfolio weighting schemes, as it can come at great carbon cost for green investors.
“The green dilution is very strong, regardless of which ESG factors and scores are targeted as objectives, with our research revealing an average dilution of 92% across our portfolios,” said Erik Christiansen, Head of Investment Solutions for Scientific Beta.
“In other words, adding combinations of ESG scores to carbon intensity as a weight determinant in developed equity portfolios dilutes 92% of the initial carbon reduction objective. Only 8% of the carbon reduction objective survived the inclusion of ESG scores in portfolio weighting schemes,” said Mr Christiansen.
The green dilution has a simple explanation: the correlation between ESG scores and carbon intensity is close to zero.
“The two objectives are, simply put, unrelated. By adding too many ESG factors, investors lose focus on the carbon reduction objective. So if you are seeking to reduce the carbon intensity of your portfolio, you need to prioritise the decarbonisation objective,” Mr Christiansen said.
The Scientific Beta research reveals that the lack of correlation between carbon intensity and ESG scores holds true even if companies’ carbon intensity — their carbon emissions per unit of revenue or market capitalisation — is compared to their environmental rating.
“ESG ratings have little to no relation to carbon intensity, even when considering only environmental factors underpinning ESG ratings,” said Mr Christiansen.
Scientific Beta’s analysis is extensive, having included 25 different ESG scores from three major global ESG rating providers.
“Even just using environmental scores, rather than a range of ESG factors, leads to a substantial deterioration in carbon performance. You get a worse outcome by mixing social or governance ratings with carbon intensity objectives, which typically results in creating portfolios that are less green than the comparable market capitalisation-weighted index. In other words, including social and governance scores more than completely reversed the carbon reduction objective,” Mr Christiansen said.
This dilution can be avoided through a separation approach, whereby ESG scores are used only for screening whether companies are included in a portfolio, then using carbon metrics to determine the portfolio weights.
“This conclusion arises naturally from the fact that ESG ratings and carbon intensity metrics are unrelated to each other. Our findings are robust across different ESG ratings providers, different carbon metrics and emission scopes, and different portfolio weighting schemes.”———–
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