Deconstructing ESG scores: How to invest with your own criteria

Here’s a note from Roy Choudhury about this paper:

BIS Working Paper series “Deconstructing ESG scores: How to invest with your own criteria” is an excellent paper that outlines the key challenges in implementing investment strategies based on ESG scores which are an amalgamation of broad range of fundamentally different factors.

– Many institutional investors struggle with the inherent limitations of ESG scores – lack of transparency in the methodologies, wide divergence among ESG ratings (correlation slightly above 50% between ESG rating agencies vs. 99% for traditional credit rating), and potential conflicts of interest in the ESG Ratings.

– Devising investment strategies based on amalgamation of three fundamentally different topics can be challenging – as weak scores in one pillar may be offset by strong scores in another pillar. Shifting focus from aggregate ESG pillar scores and ratings to more granular characteristics allows investment managers to focus investment strategies on specific ESG themes (rather than ambiguous aggregates) and better track performance against the investment objectives.

– ESG performance of the portfolio can be improved through the implementation of a “best-in-class” investment strategy (exclusion of firms with low ESG scores within a specific region / sector, and reinvestment in firms in the same region / sector with high ESG scores).