MSCI has overhauled the methodology behind its ESG indices, and will launch a tobacco-free product on the back of feedback from investors.
The index giant launched a consultation in October, prompted by conversations with clients about the need for updates to the methodologies, which underpin its two types of equity-based sustainability indices: the SRI series and the ESG Leaders series. MSCI invited clients and third-parties to participate in the consultation, which resulted in conversations with “around 30 or 40 institutions globally,” it told RI.
It made a number of proposals as part of the consultation.
Investors were asked if it was time to update MSCI’s ‘worst offenders’ list – those companies involved in controversial weapons or violations of global norms (including those stated by the OECD and UN Global Compact). The list is used as a screen on a number of MSCI’s ESG indices.
The proposals included whether the existing definition of ‘controversial weapons’ should be broadened to include blinding lasers, non-detectable fragments and incendiary weapons. MSCI also asked if tobacco and coal should be included in the ‘worst offenders’ list.
The controversial weapons proposal was passed, although Véronique Menou, MSCI’s Executive Director of ESG Research, told RI “it doesn’t have any practical impact on any of the indices, as so far we haven’t flagged companies for involvement in those three types of weapons”.
The tobacco proposal did not reach consensus, and so it was not approved by MSCI, but the firm is now working on a dedicated tobacco-free product, to capitalise on the heightened interest on the topic from the responsible investment community.
“There are a number of different approaches we could take on an index like that, depending on how involved investors want a company to be before it is excluded,” explained Menou. “We could look solely at excluding manufacturers and producers, or we could look further along the value chain, or we could look at whether a firm has a parent company or subsidiary involved in tobacco.”
On coal, there was no consensus so the proposal was not approved. However, MSCI will now create a coal screen for its SRI family. This is likely to mean that those companies that generate more than 30% of their revenues from thermal coal are excluded.Investors were also asked whether the ‘worst offenders’ screen should be applied throughout the ESG index products, rather than on selected products.
“The question here was, when we talk about ESG investing, are there some minimum standards that all investors should be applying and if so, what is the consensus on basic exclusion criteria,” said Menou.
Again, there was a lack of agreement among participants in the consultation on this topic, so it wasn’t taken forward. Some – especially those invested in the low-carbon offerings – felt they were using the indices to mitigate climate risk, and do not see values-based screens as meeting their objective.
“The SRI range is usually used for values-based investments. It’s a concentrated universe, excluding controversial sectors and then applying a best-in-class approach to the remaining constituents,” explained Menou. “But the ESG Leaders range is primarily used by investors looking at long-term returns, and they aren’t showing much interest in aligning the index with their political and ethical values.”
However, when MSCI proposed removing all existing value-based exclusions from the ESG Leaders indices (some include exclusions of sectors such as gambling and alcohol as well as ‘worst offenders’), there was further disagreement.
“Some investors were really in favour, others weren’t. In the US, the value-based screening and exclusion approach tends to be seen as important – the US considers all ESG as automatically including some ethical aspect, as opposed to Europe, where it can often be seen as strictly financial.”
Other changes to MSCI’s ESG methodology include the removal of an ‘ESG buffer’ so that companies that have fallen down MSCI’s ESG ratings to a ‘B’ score or lower will now be excluded.
MSCI will also include a ‘trends’ element to its index methodology, on the back of client demand. This means that when a company’s ESG rating improves year-on-year, it will be scored more highly. If it scores less year-on-year, it will be marked down on the basis of a “negative trend”.
“Investors are increasingly demanding dynamic indicators, rather than static ones. This method allows us to capture the trajectory a company is on, and can help identify future ESG leaders.”
This additional will be made across both types of MSCI ESG index – Leaders and SRI.
The exact time frame for implementation is currently undecided, Menou told RI, but the changes are imminent.