Source: spglobal.com

According to spglobal.com,

“The Dow Jones U.S. Select Green REIT Index is designed to measure the performance of publicly-traded real estate securities in the Dow Jones U.S. Select REIT that meet sustainability criteria. The index attempts to improve GRESB Total ESG scores exposure with respect to the underlying index by overweighting those companies with relatively high GRESB scores and underweighting those with lower or zero scores”.

The outperformance of the Dow Jones US Select Green REIT Index is evident. While S&P 500 has given 18.7% returns year-to-date, the Dow Jones US Select Green REIT Index has given 26.82% returns so far this year.

It is estimated that 40% of all global carbon emissions are driven by the construction and operation of buildings. This magnifies the importance of ESG in real estate by multiple times and calls for further scrutiny of the sector.

The process of portfolio exclusion decision at NBIM

The exclusion from an investment portfolio due to ESG investing filters has become a more regular occurrence over the last eighteen months and the largest funds of the world are taking a lead in this. Some of the funds will talk about it a lot more than others while some will do it without any noise.

But this is a phenomenon that is rather difficult to miss. So, when Norges Bank Investment Management decided to exclude four companies from the Government Pension Fund Global at the beginning of this month, the reaction was subdued. The markets expect these things to happen.

Norges Bank decided to exclude Elco Ltd, Ashtrom Group Ltd, and Electra Ltd due to unacceptable risk based on the companies’ activities associated with Israeli settlements on the West Bank. Also, Oil & Natural Gas Corp Ltd from India was excluded because of the company’s ties to groups that seriously violate human rights in South Sudan.

What is more interesting is the time lag between the recommendation to exclude from the Council on Ethics at Norges Banks and the final decision. For the first three companies, the decision was based on recommendations on 15th March 2021. In the case of Oil & Natural Gas Corp, the decision is based on a recommendation on 8th January 2021.

But that is for a reason. Norges Bank explains “The Executive Board is satisfied that the exclusion criteria have been fulfilled. Before deciding to exclude a company, Norges Bank shall consider whether the use of other measures, including the exercise of ownership rights, maybe better suited. The Executive Board concludes that it is not appropriate to use other measures in these cases.“

For the funds and their asset managers, between a hasty outright exclusion at one end and an endless process of engagement at the other, what Norges Bank Investment Management has done seems like a more sensible approach.

Think, analyze and then decide. In some cases, the engagement may not yield results. But asset managers must look at the companies individually and not just on the basis of which sector is good and which sector is bad. And when nothing else works, excluding the company must be exercised.

How EMAlpha can help?

Investors are increasingly integrating ESG into their investment decisions. While this is a positive step for the ESG movement, the investors have to tread with added caution. ESG as a term encompasses a wide spectrum of metrics. The real value lies not in the wider coverage but rather in the specific, more granular coverage. For instance, Amazon. While the company has very good “environmental” credentials, the story is much different when it comes to its “social” credentials. The company has courted numerous controversies over the years regarding its warehouse working conditions. If an investor goes solely by the overall ESG score of Amazon, they would be downplaying the critical risks posed by the company’s lack of “social” credentials. The same goes for Tesla as well. While Tesla scores big in the “environmental” aspect due to its line of business of producing electric cars, the company didn’t use to fare well on the “governance” front. Although that is gradually changing, it is something that an investor must keep an eye out for.

It thus is clear that an investor mustn’t get swayed away by the goodie-looking overall ESG score. Rather the investor must go deep and look for the sector-specific disclosures and granular details concerning the company. Factors that affect the ESG scores of a rubber manufacturing company may not be the same as those that affect an FMCG company. Hence, it becomes prudent to discern ESG scores using a sector-specific lens.

On the basis of AI-ML based analysis of the available news flow on ESG ratings and data products providers and our interaction with the sustainable finance ecosystem, we think it is clear that a) very few people need readymade ratings, and more people want quality data, b) different clients need different pitch and for that solid background research is necessary, and c) because of conflict of interest, ratings are not advisable to be offered by everyone nor are they for all the asset managers unless they know how to use them and what is going on in the process.

At EMAlpha, we have incorporated a Flexible Framework Management System, based on EMAlpha’s proprietary technology making inferences framework agnostic. This also offers a quick adaptation for the users (asset managers, companies, and investment advisors). As such, the EMAlpha’s ESG and Sustainability offering is centred around addressing some of the most critical issues.

The EMAlpha algorithms provide a choice for separate relevant frameworks and these can be used to review the performance more transparently. This not only helps the investment advisors but also makes the clients understand the granular details better which in turn is helpful for them to understand their preferences better. To achieve this, we focus on the following;

• Go beyond the official reported version – The data source matters and there is a need to look beyond what the companies are reporting and what the official version is. It is essential to rely on the company-reported data because other sources might not be collating as much information. Although often, there are other sources as well for environment-related information. They include the information disclosure as mandated by regulators and the EMAlpha algorithms scan through unstructured data to pick the unofficial information too.
• No two ESG scores are the same despite the same headline figure – It is the composition that makes a big difference and all the three parameters that make up ESG need to be evaluated separately. The EMAlpha algorithms provide separate scores for E, S, and G so that an investor can review the sectoral performance more transparently. Over and above, a key feature of EMAlpha’s NLP algorithms is that the attribution analysis is fairly simple and straightforward.

• An ESG score without context and background is meaningless – The ESG is as much about intent as it is about execution. For this balanced evaluation, having an understanding of the local factors is very crucial. A very good ESG track record (probably more driven by excellent performance in E and/or S) may hide serious Governance related risks and the investors can only ignore them at their own peril. EMAlpha analysis meticulously incorporates this critical part of the ESG evaluation jigsaw puzzle.