Developing an ESG scorecard

ESG is neither an asset class nor an investment factor. It is an analytical tool, and it's not just for tree huggers.

By Margaret M. Towle

(About the author: Margaret M. Towle, PhD is managing director at Avrio Technology, where she oversees the firm’s investment offering. Her career spans a 30-year period as an asset manager, investing across multiple asset classes. For the past several years, she has focused on ESG investing, including the development of ‘The ESG Scorecard.’ She can be reached at

SEATTLE (Callaway Climate Insights) — I do not consider myself to be either a tree hugger or do-gooder yet I do use environmental, social and governance metrics to increase my odds of superior performance.

First and foremost, I am an investor looking for opportunities to capture market inefficiencies. I base my investment approach on a set of assumptions about what is happening in the world today. I then validate these assumptions with empirical data from multiple sources. Over the past several years, my partners and I have developed and recalibrated an ESG lens with which to value companies. We call it the ESG Scorecard. To me, ESG investing is all about sustainability, i.e., which companies are efficiently running their operations and effectively managing their stakeholders in such a manner that they will thrive and survive in the coming decades?

Welcome to the 21st century

It is predictable, although tiring, to hear so-called market gurus use outdated assumptions, out-of-sample data and spurious correlations to call BS on ESG investing. To me, ESG investing is neither an asset class nor is it a single investment factor. Instead, I view ESG investing as a robust analytical tool with which to measure non-financial key performance indicators (KPIs) on an industry-by-industry basis. In fact, numerous academic studies now confirm the linkage between positive ESG practices and superior performance. ESG-centric companies enjoy:

  • Lower cost of capital

  • Higher market valuations

  • Higher productivity

  • Higher return on assets & return on equity

  • Fewer bankruptcies

… all of which can contribute to stock market outperformance.

Many years ago, factor investing was all the rage. Prevailing wisdom taught investors that factors such as value, growth, or quality, i.e., financial factors, were significant drivers of return. However, while focusing exclusively on financial measures to make investment decisions made sense decades ago, it does not now. Why? Over 40 years ago, approximately 80% of the value of the S&P 500 consisted of tangible assets, such as inventory or buildings and equipment. Today, more than 80% of the value of the S&P 500 consists of intangible assets, such as intellectual property or a company’s brand. Thus, to effectively conduct company analysis in the 21st century requires integrating non-financial performance measures, specifically ESG key performance indicators, within your investment process.

The yin and yang of climate change investing

This all sounds well and good, but how does an investor go about applying these metrics to climate change investing? In general, investing is all about finding opportunities and managing risk exposures. Due to the complex, dynamic, and fragmented nature of global warming, investors will benefit by using a holistic integrated approach of fundamental (financial) analysis combined with ESG (non-financial) metrics. For risk management, in addition to the traditional tools around portfolio construction, we use digital tools — including artificial intelligence and unstructured data — to assess investor sentiment and detect potential controversy (reputation) risks.

Our investment process fuses a top-down global macro thematic perspective with an industry-specific bottom-up stock selection process to unearth climate change opportunities.

Our top-down domains of focus include climate change, biodiversity and conservation, healthy oceans, water security, clean air, and weather and disaster resilience. Our stock selection process ranks each company relative to its peers on an industry-by-industry basis using the Sustainability Accounting Standards Board (SASB) ESG industry classification system.

First, we score each company within its unique SASB industry category and then compile a peer group ranking of companies within each industry. Next, we select best-in-class within each industry group. As a final step, we use a two-part screen to identify tangible and intangible company risks. Since a growing proportion of corporate value is intangible, we supplement our risk management process evaluation of traditional company reported data with output from unstructured data and artificial intelligence technologies. This allows us to better assess stakeholder sentiment and external reports of corporate ESG behavior to uncover hidden risks such as controversy risk — and ideally avoid greenwashing behavior.

An illustration (not meant as an investment recommendation)

One of our favorite top-down global themes is harnessing the technologies of the Fourth Industrial Revolution, or 4IR, for the betterment of mankind. To us, 4IR represents a holistic collection of technologies that is blurring the lines between the physical, digital and biological spheres.

We believe that 4IR technologies offer innovative strategies to reverse and/or mitigate the negative effects of climate change. For example, computer centers consume tremendous amounts of energy and will continue to grow exponentially into the next decade. Applying 4IR technologies, such as artificial intelligence and related technologies, including machine learning, offer the potential to enhance computing efficiency.

To illustrate, Nvidia (NVDA), one of the world’s top semiconductor manufacturers, is known as a leader in AI and machine learning. Nvidia recognized early on the importance of conversational AI, graphics rendering and deep learning. Importantly, GPUs (graphics processing units) use 1/10 the power of CPUs (central processing units). Applying our multiple ESG screens, Nvidia ranks in the top quartile on an ESG industry basis and displays moderate controversy risk.

Another semiconductor company, Texas Instruments (TXN), engineers, manufactures, tests and sells analog and embedded semiconductor chips — key ingredients in electronics. From an “E” perspective, Texas Instruments is on target to dramatically reduce its fresh-water usage by recycling a third of the water used in its manufacturing process. (A typical semiconductor manufacturing facility can use two to four million gallons of ultra-pure water per day) In addition, Texas Instruments is identifying conflict minerals in its supply chain. From the “G” perspective, Texas Instruments embodies best-in-class board diversity practices, with a 40% representation of female board members. Like Nvidia, using material ESG metrics within its industry classification, Texas Instruments screens out as first quartile and enjoys a low controversy risk score.

A few caveats

First, ESG investing represents an evolving paradigm. As such, successful investors must embrace new tools and metrics to better adapt to this changing investment environment. Secondly, no single company represents a paragon of ESG practices. Therefore, materiality matters. For example, a retailer may effectively reduce its greenhouse gas emissions through a state-of-the art distribution system yet offer little in the way of employee benefits. Which measure is more material to retailers? Thirdly, transparency is a two-way street. If asset managers desire greater corporate disclosure and transparency, then they must be willing to disclose their methods and conclusions.