Deconstructing ESG scores may unlock value, and may impact Shari’ah compliant investments differently

  • Separating ESG into E, S and G allows investors increase their investments’ relevant ESG score without incurring a financial cost to their returns
  • A simple analysis of RFI Foundation’s research on ESG and Shari’ah screening suggests the Islamic funds should consider how they apply deconstructed ESG data within a Shari’ah screened universe

A working paper published by the Bank for International Settlements looks into the impact of disaggregating ESG scores on investors’ ability to increase the ESG quality of their investments without sacrificing returns. The research finds that it is feasible to improve scores on a more disaggregated basis focusing on environmental, social or governance objectives without incurring financial cost in terms of returns.

This disaggregation has the benefit of being clearer to understand and less likely to be impacted by the wide variations between ESG scores from different providers. The much wider dispersion of ESG scores between providers compared to credit ratings is becoming a big issue, leading those skeptical of ESG integration to question the impact of responsible investment.

After surveying Refinitiv data, the only data they could identify that disaggregate ESG scores into the underlying data items, the working paper authors look at a few types of targeted environmental, social or governance strategies. Their metric of success is to find strategies that best match benchmark indexes with limited tracking errors, avoiding under-performance on financial objectives while increasing the investments’ ESG score.

They end up finding the most effective strategy comes from using a best-in-class approach that removes the bottom quarter to a third of companies on the ESG score they look at and rebalancing the remaining portfolio by reinvesting it in a way that the final portfolio matches the original regional-sectoral breakdown.

Using this method as inspiration, it is possible to take a rough look into the RFI Foundation’s research, which also used Refinitiv’s data in comparing Shariah compliance and ESG screening on company financial performance. We looked to see if there was an uplift to company financial performance based only on E, S or G issues in a single region as well as how the Shariah screening impacts the analysis.

Using just the results we published in December 2021, it is not possible to replicate the methodology of the BIS white paper, but a simple approximation highlights a promising avenue for further research. To do this, we compared the financial performance impacts in each region, looking separately at the aggregate ESG score and disaggregated E, S and G scores. These analyses try to explain company financial performance differences based on ESG scores, Shariah compliance, and the interaction of the two, as well as a variety of controls.

We have results from the Asia-Pacific, Europe, the United States (companies with $1 billion or more market capitalization), and Emerging Markets. The relationship between ESG scores for Shariah-compliant and non-compliant companies is different, and varies across regions as well. In order to look at a similar ESG uplift as the BIS working paper (of about 15 percentage points), we take a baseline of a 50th percentile for ESG scores and compare it to the 65th percentile.

We found that on a standalone basis, an increase in ESG scores by 15 percentage points leads to a higher return on assets in the Asia-Pacific, U.S. and Europe among non-Shariah-compliant companies. And for those that are Shariah-compliant, the return on assets associated with higher ESG scores was only positive for Emerging Markets.

However, when information about E, S and G scores are compared separately, the results show the three sources of ESG data are connected with different company financial performance (in terms of return on assets). For example, there is little difference between the impact of moving up 15 percentage points on the ‘E’ score for Shariah-compliant and non-Shariah-compliant companies. However, for ‘S’ or ‘G’ there is more of a difference with Shariah-compliant companies, which mirrors the overall results where Shariah-compliant and non-Shariah-compliant companies see a different correlation between ‘S’ and ‘G’ scores and their return on assets.

In Emerging Markets, the Shariah-compliant companies saw their return on assets rise more when the social score is improving compared with non-Shariah-compliant companies. And there was less divergence between Shariah-compliant and non-Shariah-compliant companies’ return on assets when looking at changes in the ‘E’ and ‘G’ sub-score.

The results of this quick look into the RFI Foundation’s research on Shariah and ESG screening shouldn’t be taken as definitive confirmation of the BIS’s working paper. There are other factors at play that would need to be considered to analyze how Shariah screening impacts the process of using more disaggregated ESG (or ‘E’, ‘S’ and ‘G’ scores).

The rough analysis here should serve as further evidence that in most cases, it’s not enough to overlay ESG and Shariah screens on top of one another without looking into how this will affect company selection and possibly investment performance. This will be especially true as investors become more focused on the responsible investment approach of the funds in which they invest and regulations around fund labeling become more restrictive.

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Blake Goud

Blake Goud

Promoting adoption of responsible finance in Islamic markets & Islamic finance. CEO @RFIFoundation.