At Capital Group, we believe the analysis of material environmental, social and governance (ESG) issues as part of our research can help us understand long-term risks and opportunities for investors. We integrate ESG into our investment approach, The Capital SystemTM, through three interrelated elements designed to enhance our bottom-up investment research and analysis: Research & Investment Frameworks, Monitoring Process and Engagement & Proxy Voting.
The monitoring element of our investment process for corporates involves reviewing holdings against international norms and third-party ESG scores, where data is available, to identify potential ESG risks that merit further investigation. We then draw on our investment professionals’ deep knowledge and understanding of the issuer to determine the materiality to the investment case. Investment decisions are made based on a long-term view, engagement and analysis — never solely on monitoring results.
Introducing external data into our monitoring process helps guard against confirmation bias and supports objectivity in our ESG integration process.
Our monitoring criteria and review process
Capital Group uses several criteria when monitoring equity and corporate debt issuers against third-party data. We have a different methodology in place to cover sovereign debt, which will be examined in future publications.
Issuers are assessed based on how well they adhere to the norms embodied by the United Nations Global Compact. While there is no definitive list of violators or non-violators, any issuer that scores as a “fail” by our third-party data provider, MSCI, raises an initial flag to us, which prompts us to investigate the issue further.
We also look at overall ESG scores provided by MSCI and Sustainalytics, the extent to which the two sources agree, and how an issuer scores on the MSCI governance indicator. We have identified specific thresholds for each indicator that help us flag issues that are most likely to be material.
Our current criteria are illustrated in the below table.
On a regular basis throughout the year, we monitor our corporate holdings‡ to ensure that changes in scores from third-party data providers are promptly identified.
Our monitoring criteria are reviewed periodically to help ensure efficacy of the process and relevance of our data sources.
The value in considering multiple third-party ESG data inputs
On the surface, ESG data offerings from different providers appear to be similar. For example, both MSCI and Sustainalytics consider an issuer’s exposure to industry-specific ESG risks and how well they are being managed.
However, a study published by Oxford University Press found that correlations vary significantly, ranging between 0.38 and 0.71 for the major providers.§ Correlation measures the strength of a relationship between two variables: a correlation of 1 means there’s a strong positive relationship, −1 means that there’s a strong negative relationship and 0 means no relationship.
Methodological differences are at the heart of this divergence. MSCI’s ratings, for example, evaluate a company in relation to its peers in the same industry. Sustainalytics scores a company on an absolute basis according to its exposure to the ESG risks of an industry or region, accounting for a company’s actions to manage that risk. In addition, the weight given to each issue (environmental, social or governance) may vary across providers, as can the importance given to different controversies.
This evidence supports our use of multiple inputs and providers in our monitoring process. It also demonstrates the importance of researching beyond individual ESG scores.
Our monitoring process tends to flag events rather than areas of systemic risk
In early 2023, our ESG specialists reviewed approximately 200 monitoring reports completed by analysts and portfolio managers since 2021. This involved putting key questions to our investment professionals to understand whether these flagged issues were considered impactful to their investment theses. We also reviewed the flagged companies to better understand trends across industries.
Our review highlighted that external flags tend to identify certain areas of consistent underperformance (such as poor human capital management practices, clawbacks and malus clauses) and events (human rights violations, bribery scandals, conflicts of interest, etc.) more frequently than other ESG risk indicators such as systemic risk and stability, competition or instances of director removals and poison pills. In many cases, we found that the issuer in question is taking appropriate steps to remedy the source of controversy, but this isn’t captured by the third-party provider’s score. This underlines the importance of having an ESG process that incorporates research and engagement alongside monitoring. In cases where we believed the issues raised were meaningful to the investment case, we generally engaged with the issuer on those topics.
How are we disclosing our monitoring?
Funds and accounts that primarily hold equities or corporate or sovereign bonds are subject to our monitoring process. On average, between 2% and 7% of holdings (by number) are flagged, as of 28 April 2023, for additional review. We recognize that ESG transparency is important; clients value being shown how the process works in practice. Therefore, we have fund-level disclosure of the results of our corporate monitoring process — where data is available — disclosing which holdings are being flagged for in-depth review.
For illustrative purposes only.
Because third-party ratings are increasingly used across the market, it is helpful to understand this “market view” of a company and why our view may differ. Many of our clients use third-party ESG tools, such as those provided by Morningstar or MSCI, which score the holdings in portfolios. We are committed to providing transparency and disclosure of our monitoring results, consistent with how our clients may be reviewing their portfolios for other performance metrics.
Monitoring strengthens the other elements in the process
Our ESG integration process is rooted in investment materiality and enhances our investment approach, The Capital System. Monitoring is an important part of how we do this. We are also committed to driving ongoing improvement in all areas of our process, and monitoring is no exception. We review our corporate monitoring process on a regular basis to ensure it remains fit for purpose and flags material issues for deeper research. As ESG data grows and mature over time, we will continue to drive our process forward.
* Certain holdings are currently not covered by third-party monitoring providers.
‡ Corporate holdings are monitored to the extent they are covered by third-party data providers.
§ Florian Berg and others, Aggregate Confusion: The Divergence of ESG Ratings, Review of Finance, Volume 26, Issue 6, November 2022, Pages 1315–1344, https://doi.org/10.1093/rof/rfac033
ǁ Data as of 30 June 2023. UNGC is United Nations Global Compact. Donut chart: Reflects all of the portfolio’s holdings at the issuer level. The monitoring process covers 100.0% of the portfolio’s holdings, which represent 100.0% of the portfolio’s assets, excluding cash and cash equivalents. “Other” holdings are those that either do not have available third-party data or that are not currently covered in the monitoring process. The data used in the monitoring process currently applies only to equity securities and corporate and sovereign bonds. The percentage figures may not total 100 due to rounding. Largest flagged holdings table: Represents the largest flagged holdings in the portfolio (at the issuer level), indicated by asset weight based on the total assets of the portfolio, including cash and cash equivalents. Totals may not reconcile due to rounding.