Scientific Beta: How ESG scores conflict with climate investing

24 oktober 2023

Many index providers are constructing indices that combine ESG scores and climate scores. An important question for investors is the conflict that could arise when adding ESG objectives to carbon reduction objectives in equity portfolios.

By Felix Goltz, Research Director, and Antoine Naly, Senior Quantitative Researcher, both at Scientific Beta

We quantify the loss of greenness (in other words the increase in carbon intensity) that investors face when weighting stocks by combinations of ESG scores and carbon intensity.The successive growth of ESG and climate investing has led practitioners to promote strategies that aim to fulfil both higher ESG scores and lower carbon emissions, without ever considering the potential trade-off between these two dimensions.

Green Dilution

In recent research [1] we quantify this very trade-off by measuring the carbon intensity increase investors face when they add ESG score objectives to a low carbon intensity objective in global equity portfolios. Heterogeneity in ESG preferences is accounted for by relying on 25 ESG theme scores from three major ESG rating providers, and by building portfolios based on numerous combinations of ESG objectives and carbon reduction.

By comparing the greenness of portfolios built to have both higher ESG scores and lower carbon intensity to that of portfolios solely built to reduce carbon intensity, the incremental impact of the inclusion of ESG scores on carbon intensity reduction can be computed, which we call ‘green dilution’.

It appears that green dilution is pervasive, regardless of which ESG scores are targeted as objectives, substantial, with an average of 92% across our portfolios, and robust across several alternative specifications. A 92% green dilution means that 92% of the carbon intensity reduction investors could have reached by solely weighting stocks to minimise carbon intensity is lost when adding ESG scores as a partial weight determinant. Only 8% of the carbon reduction objective survived the inclusion of ESG scores in portfolio weighting schemes.

Adding a single ESG score in portfolio construction, so that stock weights are equally determined by carbon intensity and the ESG score in question, leads to a green dilution of 65% on average. Mixing ESG scores expected to be green (in other words, scores belonging to the environmental pillar) with carbon intensity also leads to a substantial deterioration in green performance. Mixing scores from the social or governance pillars with carbon intensity results in portfolios than are less green than the cap-weighted index: on average, social and governance scores completely reversed – and more – the carbon reduction objective.

ESG scores and carbon intensity don’t correlate

Green dilution has a simple explanation. The cross-sectional rank correlation between ESG scores and carbon intensity is close to zero. The two objectives are unrelated and are therefore hard for investors to simultaneously achieve. This low correlation explains why one should not mix ESG and carbon scores in portfolio weighting schemes.

A more sensible alternative is to separate the two objectives, by first screening out stocks with low ESG scores, and then weighting the remaining stocks by the investor’s key objective, in our case carbon intensity. Since both dimensions are unrelated, screening out stocks by ESG scores doesn’t affect the carbon intensity distribution of the stock universe. ESG exclusions thus result in a neutral impact on portfolio carbon intensity, with a green dilution close to zero.

Overall, there is clear evidence against the quantitative mixing of ESG and carbon scores in equity portfolio weighting schemes, which comes at great carbon cost for green investors. Conversely, evidence favours the exclusionary approach to ESG objectives to best accommodate multiple non-financial and unrelated objectives.

^{Presentation in Amsterdam}

^{At the Scientific Beta Days Europe conference at the Barbizon Palace in Amsterdam on November 14 and 15, 2023, Felix Goltz, PhD, Research Director with Scientific Beta, will be making a presentation on the topic of ´Must we Choose between ESG and Climate Objectives?´}

^{The full conference programme can be found here and complimentary registration for the conference is accessible here.}