Scientific Beta

Negative/exclusionary screening is the oldest and most widely used approach to responsible investment. Scientific Beta offers off-the-shelf and custom ESG and Low Carbon indices that include a Core ESG Filter that reflects the most consensus screening criteria applied by investors and is grounded in global norms. This document describes, justifies and analyses this Core ESG Filter.

 
Negative screening is the oldest approach to responsible investment as well as one of the most practised globally in asset terms. Negative filtering on environmental, social, and governance (ESG) themes can be justified by investors for different reasons:

• A deontological motivation is to avoid complicity with companies that violate fundamental ethical principles.
• Self-interested investors seek to avoid exposure to companies whose ESG-related risks may not be properly priced by financial markets, e.g. so-called stranded assets.
• Investors may also seek to improve the ESG performances of companies. ESG screening/divestment contributes to influencing corporate behaviour by raising the cost of capital for companies involved in activities that the investor objects to.

On this last point, it is important to use consensus- and norms-based definitions for negative ESG screening to reinforce its influence on corporate behaviour. Not only do straightforward consensus-based ESG screening strategies send clear, unambiguous signals to company management, but the signalling effect is reinforced when investors converge on which signals to send. In contrast, positive/best-in-class screening is used in ESG integration strategies that mix ESG considerations, such as ratings, with traditional financial inputs in the portfolio construction process, which may result in inconsistent or diluted signalling effects on companies due to the multitude of variables considered jointly.

Moreover, negative ESG filtering is consistent with the fact that there is no evidence of a rewarded ESG factor. Negative screening to specifically achieve ESG objectives is thus in line with maintaining a clear distinction between financial objectives, such as superior long-term risk-adjusted performance, and non-financial objectives, such as ESG considerations.

These considerations of consensus-based negative ESG screens and the importance of maintaining a clear distinction between financial and non-financial objectives are key motivations in the design and application of Scientific Beta’s Core ESG Filter.

The Core ESG Filter completely removes non-compliant stocks from the investable universe. Since it focuses on the most consensus-based and serious violations of fundamental norms, the exclusions send strong and clear signals to companies on their conduct and activities, irrespective of their overall ESG ratings or financial attractiveness. The conduct-based screens reflect violations of fundamental ethical norms and companies issuing only non-voting shares, while the product screens cover controversial weapons, tobacco, and fossil fuel activities incompatible with the Paris Agreement. The definitions applied for the screens in the Core ESG Filter are updated annually to reflect evolving consensus-based ESG themes in the investment community. The divestments thus raise the cost of capital for the companies and can complement engagement efforts to facilitate improvements in corporate behaviour. Moreover, the reduction of the investable universe due to the Core ESG Filter is limited and stable over time.

Scientific Beta’s Core ESG Filter is a component of both its multi-factor and pure ESG/Climate offerings. Under the multi-factor offering, since June 2019 Scientific Beta has offered off-the-shelf ESG and Low Carbon indices as fiduciary options, which embed the Core ESG Filter that is also available as a stand-alone filter. The ESG and Low Carbon multi-factor indices are underpinned by the principle of separating financial and non-financial objectives highlighted above. Non-financial objectives are achieved via negative screening, while financial objectives are achieved via two sources of added value by seeking exposure to well-rewarded factors and the diversification of unrewarded specific risk within the filtered universe.

In Scientific Beta’s ESG/Climate offering, the Core ESG Filter is applied in the first construction step of the Climate Impact Consistent (CIC) indices. The strong signalling effect of the Core ESG Filter complements the CIC indices’ objective of ensuring consistency between stock level investment decisions and portfolio level decarbonisation. With respect to climate change, the Core ESG Filter supports portfolio decarbonisation and helps to reduce climate transition risks since it excludes coal and tar-sands companies, both of which need to be rapidly phased out to achieve a Net-Zero consistent energy source scenario and face considerable asset stranding risks.

The Core ESG Filter is offered at no additional cost for all Scientific Beta flagship indices because we believe there should be no hurdle in aligning with important and consensus-based ESG norms.