ESG: Scoring and the Impact of SFDR
ESG is an issue that refers to the enterprise’s contribution to the environment, society, and corporate governance characteristics for sustainable development. Sustainable investment, or responsible investment, represents an investment method that incorporates sustainable development factors such as ESG into investment decision.
ESG score
Many scoring agencies such as MSCI, FTSE, Refinitiv will also perform ESG scoring based on the sustainability report provided by the corporation to help you quantify the level of ESG contribution of the company. We will introduce how the ESG score being calculated. Take Refinitiv’s report as example:
Figure 1. Screenshot from Environmental, Social, and Governance (ESG) Scores From Refinitiv, page 3
As shown in Figure 1, Refinitiv scoring system contains three different scores, namely ESG score, ESG controversies score and ESGC score. ESG score measures companies’ performance on each pillar of ESG, and ESG controversies score scales related negative news of the companies. ESGC score, which stands for ESG combine score, is the comprehensive indicator of ESG score and ESG controversies score.
Refinitiv scores by percentile rank scoring methodology. The process is based on three factors, which are the number of companies with worse performance (W), the number of companies with the same performance (S), and the number of companies evaluated in the industry (T). The calculation formula is as follows:
Take Figure 2 as example, they derive measure value of each company and then sort it by performance. Company JKL get 0.95 in TR.AnalyticCo2, which performs the best in the same industry.
After calculating the score of each category of ESG, Refinitiv sums all the category score by weight as ESG score.
ESG controversies score is calculated in the same way. After that, they compared ESG score and controversies score together. If controversies score is higher, ESG score is regarded as ESGC score. If the controversies score is relatively low, they take the average of ESG and controversies scores as ESGC score. Even if a company’s ESG score is high, if too many scandal have occurred recently, it may lower the company’s ESGC score. Controversies score can be used as a quick indicator of the company’s undisclosed information.
SFDR appears
Since the United Nations introduced the Principles for Responsible Investment (PRI) in 2006, the second ESG evolution is coming. The European Commission promoted the Sustainable Financial Disclosure Regulation (SFDR) in 2019 to prevent green-washing and carried it out in March 2021 gradually.
The most influential part of SFDR is to provide three categories of ESG financial products launched by FMP. As shown in Table 1, the strengths from low to high are Articles 6, 8, and 9 of the specification. After SFDR hits the road, all ESG products will have a unified measurement method that can be examined. Many US and Taiwan funds have begun to announce relevant information on their websites. Although SFDR only applies to the EU, it will be a deterministic factor affecting the development of the global ESG industry.
| Article 6 | Financial market participants shall include the manner in which sustainability risks are integrated into their investment decisions and in pre‐contractual disclosures. |
| Article 8 | A financial product promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices. |
| Article 9 | A financial product has sustainable investment as its objective and an index has been designated as a reference benchmark. |
Gamma Paradigm also pays attention to ESG issues and is committed to sustainable investment. In the ESG scoring standards used by the top US securities Interactive Brokers, Gamma Paradigm ranks in the top 25% of the industry. ESG is the current trend. For the sustainable development of the world, not only firms are committed to the ESG field, but funds will also exert their strength and exert influence in supervising companies. Gamma will continue to report related issues.
[1] Soohun Kim, Aaron Yoon, 2020, Analyzing Active Managers’ Commitment to ESG: Evidence from United Nations Principles for Responsible Investment
[2] David C.Broadstock, Kalok Chanb, Louis T.W. Cheng, Xiaowei Wang, 2020, The role of ESG performance during times of financial crisis: Evidence from COVID-19 in China
[3] Gunnar Friede,Timo Busch & Alexander Bassen, 2015, ESG and financial performance: aggregated evidence from more than 2000 empirical studies
[4] Five ways that ESG create value (2019)
[5] Environmental, Social, and Governance (ESG) Scores From Refinitiv (2021)
CY Yang
Intern, Quantitative Finance, Gamma Paradigm
LinkedIn
Contact us at info@gammaparadigm.com if you want to know more.
