PRISC – Policy for Responsible Investment Scoring: This is what I expected from the EU Taxonomy Expert Group

PRISC initial situation

This sustainability policy has been developed on the basis of the PRISC concept of the DVFA of April 2020 (see here and downloads under „PRISC Explanations as PDF“ in German). The terms used here correspond to the DVFA sustainability classification (English version).

PRISC at a glance

The tool comprises 8 assessment dimensions, each with three characteristics, and enables their aggregation to form a comprehensive assessment.

  1. Exclusions („avoid bad investments“, exclusions or negative screening)
  2. Impact/SDG score („good“ investments or positive screening)
  3. ESG score definition (aggregated versus differentiated ESG score)
  4. ESG score application (best-in-universe versus best-in-class)
  5. ESG score cut-off (ESG minimum requirements)
  6. ESG score measurement frequency (Incidents)
  7. Exercise of voting rights (Voting)
  8. Active attempts to exert influence (Engagement)

The tool weights all categories equally in the DVFA standard version

I only use the categories 1) to 5). I do not consider the exercise of voting rights and shareholder engagement to be efficient for most investors. I also do not take into account „incidents“ or changes in ESG scores during the year (for reasons see also https://prof-soehnholz.com/esg-investing-20-false-arguments/).

The tool is based on the assumption that investment portfolios are normally not geared to all categories, e.g. impact and ESG at the same time. For this reason, the DVFA has introduced an adjustment factor which, by default, assumes that funds only use or fulfil 4 of the 8 categories. This adjustment factor is 8/4 by default, i.e. 200%. I am using this adjustment, too.

PRISC: The basis for determining a responsible investment policy

I assume that buying shares sends positive signals and selling shares sends negative signals for share prices and thus has an influence on credit financing conditions and bonuses. Furthermore, while limited capital should be invested in a sufficiently diversified manner, it should also be focused on „good“ investments.

PRISC exclusions: More is better

In the „Exclusions“ category, I assume that more exclusions allow more „responsible“ investments. Therefore it is necessary to decide how an exclusion is defined. In SRI ETFs (Socially Responsible Investment Exchange Traded Funds), for example, or in the indices on which they are based, one often finds the indication that certain shares of company turnover are also permissible for „excluded“ segments. I believe that an exclusion should be clear. If tobacco is excluded, for example, no 5% share of sales from tobacco production should be allowed.

However, I am referring only to production and specialised suppliers or buyers/dealers. For example, a specialist tobacco trader should be excluded, but not a traditional grocer who also offers tobacco. Even a producer who does not produce tobacco himself may have suppliers and buyers who are active in the tobacco business without being excluded from the portfolio.

With regard to the number of exclusions, I am guided by the FNG market report, which lists the most frequently used exclusions in Germany (for 2019 Tab. 2.2. p. 14). Other exclusion lists include cluster bombs, ABC weapons, nuclear weapons, military weapons, etc. as individual exclusion categories. Like the FNG list, I count weapons as a single exclusion category.

PRISC Impact or positive selection: Net consideration

In addition to the so-called negative screening, one can also invest explicitly in particularly „positive“ companies. It should be borne in mind that listed companies primarily pursue their own profit targets in the interests of their shareholders and not primarily non-commercial positive impact goals.

In determining „impact“, I am guided by the Sustainable Development Goals of the United Nations, even if these are not clearly suitable for determining good companies. For example, some so-called impact indices or funds include companies like Danone because Danone produces food. In addition, traditional production or energy companies can be found in such indices/funds, simply because they have a small positive share of turnover in renewable energy which fit with the SDG goals.

I only use net sales in terms of the SDG targets. This means that a company can only be included in an impact portfolio if it generates at least 50% of its sales in SDG segments. As long as no SDG measurement standards have been established yet, one has to rely on the reports of the companies themselves or on independent data providers or determine the relevant turnover oneself, as I do.

A portfolio is considered to be the more responsible the more cumulative net sales the companies in the portfolio make in terms of the SDG targets. For example, this can reach 100% for a pure portfolio of renewable energy producers.

It should be noted that only very few listed companies generate more than 50% of their sales in SDG segments. If this point is very important to an investor, it can lead to the exclusion of the vast majority of listed investments.

A note on the relationship between categories 1) and 2): A portfolio with hard exclusions can still be without „SDG sales“. An SDG-focused portfolio, on the other hand, typically (implicitly) uses many exclusions.

PRISC ESG-Score Definition: More granular is better

ESG indices or ESG ETFs weight and/or select securities according to (aggregated) ESG assessments, but usually use only few exclusions. SRI indices or ETFs typically use several „soft“ exclusions (i.e. not 100% exclusions) and have minimum requirements for (aggregated) ESG ratings.

To compare the strictness of sustainability, I use the number of constituents in the respective index: A (physically replicating) „sustainable“ (SRI) global equities index with fewer components is typically more sustainable than one with more components (ESG).

ESG indices usually work with aggregated ESG scores. Good corporate governance can thus compensate for a poor environmental score. I believe that a separate assessment of the criteria can help to create more responsible portfolios. In other words, a portfolio that uses a minimum ESG score of 50% is generally less „responsible“ than a portfolio that requires a minimum score of 50% for E, S and G respectively before a security can be included in the portfolio.

If an aggregated ESG score is used, the following rough calculation can be made: If the top 50% of stocks are admitted according to an aggregated ESG rating, and the number of companies rated by the ESG data provider is 6,000, then 3,000 stocks are admissible investments. However, if measured separately, the admissible universe may be reduced much more, as there are far fewer than 3,000 companies that are among the top 50% in the E, S and G scores at the same time.

An ESG score can be made up of over 100 individual sub-scores, e.g. for air and water pollution, diversity, etc.. It is therefore not very practical to require minimum scores for all criteria individually. Therefore, I only use minimum requirements for E, S and G ratings. I use the E, S and G ratings from Refinitiv (formerly Thomson Reuters), which meet the minimum requirements for ESG ratings as stated in the DVFA classification document.

Best-in-Universe (BiU) is better than Best-in-Class (BIC)

It is important to distinguish whether a so-called best-in-universe (BiU) or best-in-class (BiC) process is used.

Let’s assume that only the 25% best of all companies in terms of an absolute ESG score may be included in a portfolio (BiU). In an industry-diversified selection universe, this would mean that oil companies, for example, would not be included in the portfolio. Since many investors want to invest sustainably but do not want to see too many deviations from broad indices (so-called tracking error), they usually allow the best oil companies by ESG score to be included in a portfolio (BiC).

ESG data providers typically assign ratings within groups of companies anyway. If the defined (peer) group includes only fossil energy producers, a good E-rating is usually a less environmentally friendly indication than if all energy suppliers, including those for renewables, are assessed. Likewise, a poor E-rating in an „environmentally friendly“ rating group does not necessarily mean that the best-in-class procedure is ecologically bad.

Minimum requirements for ESG scores

Minimum scoring means, for example, that the worst x% according to ESG score or separate criteria are not permitted for a portfolio. As a matter of principle, I only use stocks for direct equity portfolios that are among the stocks with the 50% best E, S and G scores from Refinitiv. Since Refinitiv, like all major rating providers known to me, uses a best-in-class rating, the restrictions mentioned in the previous section must be observed.

ESG measurement frequency: More often is not necessarily better

The measurement frequency question asks how often „responsibility relevant“ data is updated. Refinitiv and many other ESG rating agencies do this basically once a year. This is mainly due to the fact that companies collect the numerous and sometimes difficult to collect data only once a year. Moreover, ESG ratings typically do not change very much from year to year.

With automated text analyses and machine learning, it is technically possible to identify ESG-relevant incidents (events) very quickly. Changes in the portfolio could be made immediately and there is no need to wait for the annual updates of ESG ratings. However, due to the large amount of data involved, it is usually necessary to rely on machine data rather than analyst-reviewed data. In the case of frequent portfolio changes, the (trading) costs to implement such changes must also be taken into account.

Therefore, annual ESG scores are sufficient for me and I do not use the measurement frequency category to assess portfolios.

Voting and engagement are positive but inefficient

Responsible investors can generally be expected to exercise their voting rights „sustainably“. This is all the easier the fewer securities they have in their portfolio. In addition, attending annual general meetings and exercising voting rights is easier if you speak the relevant language.

However, investors with a small investment volume often only have very few shares and thus voting rights at annual general meetings. In addition, usually only a few resolutions are ESG-relevant and it is very time-consuming to monitor all possible resolutions of all companies in the portfolio.

Furthermore, (non-)sustainable corporate behaviour should have an impact on the ESG ratings of companies. I therefore do not use the voting category as an additional category for assessing the sustainability of portfolios, but advocate for not buying or selling (divestment) securities with undesirable behaviour. I assume that unsustainable behaviour of companies in my portfolios will rarely occur due to the many exclusions used and the strict ESG requirements.

Shareholder engagement goes beyond passive voting over decision options presented by the company. Engagement is intended to actively influence responsible corporate behavior.

Investors who wish to invest on a broadly diversified basis always have shares in companies in their portfolio that are not (yet) consistently responsible and where engagement can generally lead to improvements.

However, the restrictions made for voting apply even more to engagement, which is why I do not use this instrument or assessment category for my portfolios either.

PRISC Calibration

The DVFA Sustainable Investment Commission has applied its standard scheme with 8 equally weighted categories to some large „sustainable“ institutional funds and ETFs. Without adjustment, hardly any „responsible“ fund exceeded the 50% PRISC score. However, the best responsible funds should generally have the chance to achieve a perfect score. Therefore, the DVFA initially uses an adjustment factor of 200%. This means that a portfolio that would achieve 40% is calibrated to 80% score. The DVFA wants to check the calibration regularly and adjust it to market conditions.

Although I only use five of the eight categories, many of the so-called „sustainable“ funds known to me reach only less than 50% of the possible score without calibration. Therefore, I keep the 200% calibration of the DVFA.

PRISC scores for the portfolios of Diversifikator (as of April 2020)

Here are the PRISC Scores for my portfolios (see www.diversifikator.com; some of the portfolios listed below are not yet online) according to my „policy“ with 5 categories used, each with 20% weighting and an adjustment factor of 200%:

  • World Market Portfolio Basic and Alternative ETF-Portfolio: These portfolios do not follow a sustainability approach and therefore have a PRISC score of 0%.
  • Islamic ETF portfolio (5 relevant exclusion categories but no complete exclusions as 5% turnover is tolerated by the ETFs, therefore I mark only 1-3 exclusion categories; no ESG requirements with regard to the individual shares in the ETF): 13% PRISC result
  • Impact ETF-portfolio (estimated 4-6 exclusion categories, as e.g. via infrastructure and biotech/healthcare undesirable segments such as fossil fuels, genetic engineering and animal testing may be included; therefore only between 70% and 90% estimated impact turnover instead of 100%; no ESG requirements for the stocks included in the ETFs): 53% PRISC result
  • ESG ETF-portfolios (although ESG or SRI ETFs usually contain more than 3 exclusion categories, they also allow up to 5% or sales with „excluded“ segments, so I mark 1-3 exclusions; ESG scores are measured on an aggregated basis using best-in-class (BiC); usually ESG scores <50% are excluded): 80% PRISC result
  • All direct ESG equity portfolios except my Impact ESG portfolios (10 hard exclusion categories; E, S and G are measured separately with minimum scores of 50%; use of a mixture of best-in-class and best-in-universe because the data provider does not provide pure best-in-class): 147% PRISC result
  • Impact ESG portfolios (see ESG share portfolios, furthermore only stocks from impact market segments are used): 187% PRISC result

These results show the limitations of sustainable ETFs and why I consider my equity portfolios to be particularly sustainable.

There are no excuses left not to invest in a responsible way (see https://prof-soehnholz.com/esg-first-or-responsible-investments-no-excuses-left/).

This text has been mainly translated by www.DeepL.com/Translator (free version)

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