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Systematic Measure of Sustainability

Stockholm (NordSIP) – As the popularity of sustainable investments continues to grow, asset owners need to be able to sort the wheat from the chaff. Claiming to be ESG-compliant is easy, but measuring it can be challenging.

At a recent event in Stockholm, Ashley Lester, Head of Systematic Investments at Schroders, discussed some of the challenges of ESG integration. “It is possible to integrate sustainability into a fund, and if done well it can make a difference,” he explains.  To solve this problem, Schroders developed SustainEx, an in-house analytical tool used to internalise the externalities companies impose on society.

ESG Data Inconsistencies

The issue of sustainability is particularly relevant for Lester. Sustainability is one of the six elements of his multi-factor strategy fund. However, data problems pose a hurdle. “The easiest way to invest sustainably is to use some off-the-shelf ratings, such as those provided by the main ESG rating agencies, and apply them to one’s portfolio,” Lester explains. “These ratings are typically composites that take some set of underlying variables. ESG ratings will vary significantly depending on the variables chosen and on the weight given to each variable in the construction of the rating.”

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“The difference reflects what ESG rating providers think is important. However, the probability of agreement between any two data providers is not much greater than the odds of rolling two six-sided dice with the same number,” says the Head of Systematic Investments. “The fundamental driver of this inconsistency in ESG ratings across providers – far more than data – is the way that ‘sustainability’ is conceptualised. Fundamentally the problem is that ‘sustainability’ is not an objective variable.”

Ashley Lester, Schroders

Biases Undermine ESG Funds’ Performance

Asides from the confusion generated by the inconsistencies across ESG Rating providers, there is another problem with sustainable investments. “One common thread of basic index-based ESG approaches is that historically, they have not done very well,” Lester adds.

Despite the inconsistencies introduced by the different ways that ESG rating providers conceptualise sustainability, Lester argues that there are common underlying features shared by many providers. It is these similarities that cause the underperformance of ESG strategies.

“Because large-cap companies tend to report better, they tend to enjoy better ratings on average,” the quantitative manager explains. “As the ESG ratings are the result of an arbitrary collection of weights, data providers cannot readily normalise their ratings to take into account the size of the company,” Lester adds.

“Across most providers, the larger the capitalisation of a company, the higher the ESG rating is on average. However, on average, over time, larger companies underperform smaller companies”.  ESG ratings also appear to be biased in favour of specific sectors, which may expose investors to added risks over and above what investors seeking to invest sustainably may desire.

“We need to think more closely about how we measure sustainability and how not to introduce unintended biases into our investment processes. This is what SustainEx does.”

Fundamentally, the difficulty with sustainable investments is that it is trying to weight the value and the cost of different things. “We are comparing apples and oranges, and the problem is that different providers weight apples and oranges differently. Therefore, there is no unique way to say which company is more sustainable than another.”

Apples, Oranges and the Price of Death

One way to solve this problem is to follow the strategy adopted by macroeconomists when they construct GDP. “I have never seen a thing called GDP,” remarks Lester, who has an Economics PhD from MIT. “However, I can add up apples and oranges and sustainable multifactor funds by using their respective prices. Adding those things and weighing them at market prices is how we construct GDP.”

“The problem is that, by definition, there is no market price for externalities. That’s why companies do too much of it,” Lester reminds us. The solution is a cost-benefit analysis, which allows us to arrive at an estimate of what the efficient price of death on a construction site or of a chemical spillage is, for example.


“SustainEx weights the different externalities that companies impose on or provide to society at our best guess of what the efficient price of those externalities would be,” says the Head of Systematic Investment.

According to the quant, companies’ positive societal contributions fall into one of three main categories: They can pay employees more than it costs for them to live in the societies in which they work. They can provide power and connection to communications, and they can undertake research.

On the other hand, by far the worst externality that companies can impose on society is unpriced carbon dioxide emissions. Beyond that, the damages caused by tobacco, weapons, alcohol, gambling, water usage and fertiliser in agricultural activities and the cost to the financial stability of major systemic financial institutions are some of the main externalities covered by SustainEx.

“With this tool, we can estimate which companies and which sectors impose the higher costs on societies,” Lester says. The results are often counterintuitive. Facebook and a lot of the tech companies generally rank poorly according to this approach because they do not pay their fair share of taxes. On the other hand, SustainEx rates Nestlé well because of the wages it pays its workers.

Picture © NordSIP (featured image from left to right: Ashley Lester, Senait Asgede and Belinda Gan from Schroders)

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