The Complex Formulas Of Responsible Investing

Distinguishing good from evil on Wall Street is a challenge. Be grateful there are analysts doing most of the homework for you.

An ethical portfolio excludes the shares of irresponsible companies. Which ones are those?

Once upon a time that was a fairly simple matter. A handful of mutual funds had portfolios omitting certain industries, such as weapons, alcohol and tobacco.

Today, separating good equities from sinful ones is an industry unto itself. There are thousands of analysts at work judging corporations on their carbon footprints, gender equity, workplace diversity, mining disasters, animal testing, water usage, privacy breaches, occupational safety, boardroom scandals and impact on ocean life.

The bad news for investors struggling to align their portfolios with their beliefs is that ethical evaluations are very complicated. Do you put money into Tesla because it is part of the transition away from carbon, or shun it because of its workplace controversies? Own PepsiCo because food companies don’t pollute the atmosphere, or stay away because junk food causes obesity? Favor EQT because displacing coal with natural gas helps the planet, or refuse to own it because natural gas is still a fossil fuel?

Consider the chain of causation when somebody drives to work. The culpable party might be the oil company that supplied the fuel, the car maker that supplied a combustion engine instead of an electric one, the employer that didn’t have this worker telecommuting or the guy who got behind the wheel. An ESG evaluation might well assign black marks to any of the four players except the last one.

Tracing environmental damage potentially goes well beyond laying blame for the combustion of carbon fuels. Electric cars don’t emit carbon dioxide, but they draw from a grid that has carbon-burning powerplants. The grid needs switchgear; the switches contain sulfur hexafluoride, which is 22,300 times as potent a greenhouse gas as CO2.

The good news is that you don’t have to undertake the necessary calculations yourself. You can crib from the research done by ESG monitoring firms that have produced a wealth of data, some of it available for free. You won’t agree with all of their judgments, but you can get ratings that will, at least, steer you toward firms more likely to be compatible with your investing values.

The two big players in this market: MSCI, a firm best known for creating stock indexes, and Sustainalytics, a subsidiary of market data firm Morningstar. The paying subscribers at either of these services get elaborate reports detailing ESG risks at each public company in the database. Nonpaying viewers get a few numerical scores or letter grades that summarize a company’s degree of alignment with social and environmental goals.

There’s a big difference between MSCI and Sustainalytics in what the scores represent. MSCI grades on a curve that has companies grouped by industry. Sustainalytics, in contrast, compares a corporation to all the other 14,536 corporations in its data set.

Consider Schlumberger, which is in the business of helping drillers extract fossil fuel from the ground. Sustainalytics gives it a middling risk grade of 24.3 on a scale that has companies with low ESG risks scoring between 0 and 10 and those in the very hazardous range scoring 40 and up. MSCI is kinder to Schlumberger, awarding it an overall ESG rating of AA, near the top.

How can MSCI call Schlumberger a good guy? In the detail behind the rating MSCI has this company performing at the average in three factors (corporate behavior, health/safety and toxic emissions), while it’s among the best (“ESG Leader”) in three others: corporate governance, biodiversity/land use and carbon emissions. The double-A grade becomes less perplexing when you see that Schlumberger is being compared, not to innocent companies selling software or groceries, but to other energy companies.

For investors who are not absolutist in their condemnation of polluters and other offenders, there is some merit to the MSCI approach. They can use the MSCI grades to create a pretty well diversified portfolio whose performance wouldn’t veer too far from that of the whole stock market.

The Sustainalytics ratings are especially useful to an investor who would rather have a fund than a home-made portfolio. The Sustainalytics numbers are fed into Morningstar’s fund analysis pages, which display a composite ESG score computed from the fund’s holdings.

At Morningstar.com we see that the Vanguard Total Stock Market ETF (VTI) has a carbon risk score of 6.7. Calvert Equity (CSIEX), from a fund family that has been promulgating socially responsible investing since 1982, gets a carbon risk score of 3.6; its largest positions are in Thermo Fisher Scientific and Microsoft. At the other end of the spectrum is Fidelity MSCI Energy (FENY), whose largest positions are Exxon Mobil and Chevron; it gets a carbon risk score of 37.1.

What corporations look good in the Sustainalytics rankings? Below, for each of 11 industry groups, the two firms with the lowest overall ESG risks:

The list might raise your eyebrows. It includes oil and gas pipeline operators, a retailer whose customers are primarily working to maintain gas-burning cars and a publisher that provides a platform for global warming skeptics.

If you are disappointed with the outcome, do understand that Sustainalytics is not trying to assess corporate virtue. Its aim is rather to measure the extent to which a company has environmental and social risks that are not well controlled. Thus, pipelines are part of the same fossil fuel chain as offshore oil producers, but they are not as likely to suffer a catastrophic leak. Fox Corp. has controversial content but not a big risk of damage from a strike.

There are four ways that ESG assessments can translate into stock selection for a portfolio.

The first method is to make a list of no-go industries. The Vanguard ESG U.S. Stock ETF (ticker: ESGV) rules out companies involved with alcohol, tobacco, weapons, fossil fuel or nuclear power. Fidelity Investments will soon be offering a new robo-advisory service with a sustainability feature. It will shun tobacco but not alcohol. It will allow some weapons companies but not any that make cluster bombs or civilian semi-automatics. Coal is out, but an oil and gas company is okay if it doesn’t hold any reserves.

The second method is to accept that all publicly traded companies are in some way flawed but strive to own the ones that are the least bad. This approach is often combined with the first. Thus, Fidelity’s sustainable portfolios will, having removed banned industries, select from the permissible universe those companies that do best on biodiversity, packaging waste, carbon emissions and other factors.

In a similar vein, the Vanguard fund prefers the shares of companies that appear to be more benign on ESG measures. Some fine distinctions must be made. The fund owns Newmont Corp. but not Barrick Gold Corp. These are both in the environmentally hazardous business of extracting gold from the earth, but evidently Barrick earns some additional demerits. Sustainalytics gives it an overall ESG risk of 34 (high), versus 23.2 (medium) for Newmont.

Diesel engines stink up the atmosphere. The Vanguard fund owns Caterpillar, which installs those engines in its earth-wrecking equipment, but not Cummins, which makes the engines. Meanwhile, if carbon footprints are your primary concern, you might reject both of the gold miners and both of the heavy equipment outfits. MSCI puts all four of them down for behavior consistent with a climate warming of 4 degrees centigrade or worse (“on track for warming that would contribute to a climate disaster”).

A third way of doing sustainable investing is to seek out the good guys. The SSGA Gender Diversity ETF (SHE) owns companies that are doing the most to move women into executive roles. Any number of sector funds are available to steer your equity capital into clean energy.

The last angle of attack is to be indiscriminate in portfolio selection but very attentive to governance. That’s what you get with broad-market iShares funds. These are run by BlackRock, whose chairman, Larry Fink, controls a lot of proxy votes and is crusading for decarbonization and racial equity.

An interesting governance play is the Engine No. 1 Transform 500 ETF (VOTE), which owns big companies, good and bad, but vows to use its vote proxies for good causes. The tiny ($300 million) fund has already scored a success. Teaming up last year with other activists, it put three environmentally minded directors on Exxon Mobil’s board. These rebels may push Exxon a little faster than it otherwise would have gone in the transition away from carbon fuels.

A philosophical question for ESG investing is whether makes the planet a better place. Probably not, if you are looking for a direct impact. Turning down your thermostat keeps carbon out of the atmosphere. Selling your Exxon stake does not. Given how many ESG-indifferent investors stand ready to buy disfavored stocks, the ESG movement probably does not even budge share prices.

But the ESG crowd might well succeed by shining a spotlight on corporate decisions. Four decades ago a divestment campaign put pressure on U.S. corporations doing business in South Africa, and that pressure in turn helped end apartheid. Says Jon Hale, who is head of sustainability research for the Americas at Morningstar: “Divestment does send a signal.”