How ESG objectives “dilute” green portfolios

Yasmine Raso

Senior Journalist, Financial Newswire

10 August 2023

A new study from Scientific Beta has found investment strategies that claim to achieve higher environmental, social and governance (ESG) scores are neutralising its potential to achieve lower carbon emissions.

Titled Green Dilution: How ESG Scores Conflict with Climate Investing, the research compared the impact of portfolios built to achieve higher ESG scores and lower carbon intensity with that of portfolios only constructed to reduce carbon intensity, revealing how the inclusion of broader ESG considerations into the portfolio diminished its ability to lower carbon intensity.

The authors, Noël Amenc, Felix Goltz, and Antoine Naly, called this phenomenon “green dilution” and found it existed in an average of 92 per cent of portfolios from different providers, with only eight per cent of portfolios with a carbon reduction objective surviving the inclusion of ESG scores in weighting schemes.

“We find that mixing ESG ratings with carbon intensity objectives leads to a heavy dilution of portfolio greenness,” the report said.

“Averaging ESG scores and carbon intensity in weighting schemes effectively cancels out the carbon reduction objective.

“Mixing scores from the social or governance pillars with carbon intensity routinely results in portfolios than are less green than the cap-weighted index: on average, social and governance scores more than completely reversed the carbon reduction objective.”

The study showed that the cross-sectional correlation between ESG scores and carbon intensity is close to zero, thus making it difficult for investors to achieve all at once. The authors suggested in the report that the two objectives should be kept separate during the portfolio construction process, where stocks with low ESG scores can be screened out and then the remaining stocks can be weighted against the investor’s key objective of carbon intensity – or vice versa.

“The carbon intensity reduction of green portfolios can effectively be cancelled out by adding ESG objectives,” Felix Goltz, co-author, and Research Director at Scientific Beta, said.

“If you add more unrelated criteria, you are not going to perform well on all of them, so you have to think about your priorities. By adding too many you are losing the focus.

“If you are interested in reducing the carbon intensity of your portfolio, you are going to get that only by focusing on the carbon intensity, otherwise you are very quickly going to be getting green dilution.”