Tesla’s potential inclusion in the S&P 500 ESG index next year has resurfaced one of the key issues facing ESG ETF investors, the huge disparity of ratings between the ESG data providers.
While the US’s most valuable automaker was finally admitted to the S&P 500 on 21 December, S&P Dow Jones Indices is yet to reveal whether the company meets the sustainable scores required to join the ESG version of its flagship index.
The decision effectively comes down to the ESG score Tesla is given next year by SAM, S&P Global’s ESG data provider, and is a quantitative and qualitative ratings system based on both data provided by the company itself and the public information available.
The qualitative element of the ratings and the way the data is interpreted leads to striking divergences between the different data providers with some firms such as MSCI giving Tesla a high ESG score based on its contribution to environmental solutions while others such as FTSE Russell score the electric vehicle manufacturer poorly based on its governance.
Highlighting this, Tesla is the largest constituent in the $5.6bn iShares MSCI USA SRI UCITS ETF (SUAS) with a 7% weighting while it accounts for roughly 0.06% of the HSBC USA Sustainable Equity UCITS ETF (HSUS), which tracks the FTSE USA ESG Low Carbon index.
Why does this matter? While Tesla is just one example, it is clear to see how this divergence in metrics can lead to significant differences in the way ESG indices are constructed.
This not only drives huge differences in performance but also in the suitability of an index from an ESG perspective.
State Street Global Advisors (SSGA) summed up the issue nicely in a 2019 paper: "Differing methodologies have implications for investors. In choosing a particular provider, investors are, in effect, aligning themselves with that company’s ESG investment philosophy in terms of data acquisition, materiality, and aggregation and weighting.
"This choice is complicated by the lack of transparency into those methodologies. Most data providers treat their methodologies as proprietary information. By relying on an ESG data provider’s score, asset owners are taking on the perspectives of that provider without a full understanding of how the provider arrived at those conclusions."
For more details on this, do have a read of ETF Stream's 2020 report, entitled ESG Unlocked: From Data Input To ETF Creation, where we analyse the different parts of the ESG value chain.
Furthermore, Tesla’s potential inclusion in the S&P 500 ESG index has also brought to the fore the concept of direct indexing which enables investors to add or delete stocks from indices.
While direct indexing does stray into the active management arena, it makes perfect sense in the ESG space as it gives investors the power to remove certain companies that do not align with their sustainable values.
Instead of being left beholden to the interpretations of MSCI or Sustainalytics, investors can take their methodologies as a starting point and tweak from there. This seems a sensible approach especially in the case of Tesla where views can differ substantially.