University researchers have created a mathematical model to work out the most cost-efficient level of ESG for an investment portfolio.
Sebastian Utz, professor of climate finance at the University of Augsburg in Germany, and Ralph Steuer, a business professor at the University of Georgia in the US, published their findings in a paper titled Non-contour efficient fronts for identifying most preferred portfolios in sustainability investing.
“We wanted to understand how integrating ESG characteristics into portfolio decisions had an impact on risk and return, and how you can find the best trade-offs between these three elements,” explained Utz, adding that while most investors screen out companies with low ESG scores before undertaking the financial optimisation process, this model makes ESG performance an investment objective alongside risk and return.
The paper claims this approach is more suited to “serious ESG investors”.
A growing number of strategies invest in companies that score above a certain threshold on ESG, based on third-party assessments. “But that doesn’t tell you how your financial profile has changed compared with a portfolio with a slightly lower ESG requirement, for example,” said Utz.
“It also doesn’t allow you to see whether you can get a portfolio with higher ESG scores for the same financial profile. It just gives you the best risk/return combinations within those very small perimeters. This model takes a range of scenarios and calculates sensitivities for all of them, giving you an infinite number of more efficient portfolio options.”
Using Sustainalytics scores from around 2018, which combine ESG risk metrics with those associated with environmental and social impact, the model works out the point at which an investor can achieve the greatest rate of increase in a portfolio’s scores without significantly compromising expected returns.
“If we reduce the expected return by just 1 basis point per month we can increase the ESG score of the overall portfolio by around 10%,” explained Utz. “But if you reduce the expected return by 10 basis points per month, you only increase the ESG score by up to 20%. It shows that accepting a negligible reduction in returns gives you a high potential to increase your ESG performance, but the further away you go from this financially optimal portfolio, the more expensive extra ESG performance becomes.”
The model has also been tested using other sustainability metrics and providers, such as carbon scores from Trucost and ESG scores from Refinitiv. Utz said the findings were similar each time.
The research may prove controversial, given the increasingly popular belief that ESG performance does not require investors to compromise returns. But Utz told IPE that, while the model is built on the assumption that optimising financial performance requires a compromise on any other objective, “this is the mathematical model and the outcome may be different in practice”. But, he added, it serves as “a guide on what to expect”.
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