ESG Characteristics of a Portfolio. There are numerous reasons why a fund manager, an investment consultant, or a client would want to learn about the ESG characteristics of a portfolio. One of these reasons is to measure the exposure of fund to climate-related risks arising from the inclusion of certain securities in the portfolio. Alternatively, you may want to understand how sustainable the fund is or just how well a fund scores on ESG matters in general. The ESG-related characteristics would be assessed by supplementing the traditional metrics such as portfolio return and risk, the positioning asset class, sector, or stock positioning relative to the benchmark. So what are the ESG characteristics of a portfolio? Well, one of the most common characteristics is the carbon footprint of the portfolio and this is usually calculated using the greenhouse gas, or GHG, protocol standards. The use of carbon footprinting applies the international accounting tool that defines different scopes of direct and indirect emissions of the company. Scope one emissions are direct emissions from the operations of the company. Scope two emissions are indirect emissions from the electricity used by the company. Scope three emissions are indirect emissions from related operations in the supply chain. Analysts typically focus on scope one and scope two emissions as these are the most controllable emissions by the company. Total carbon emissions, or scope one and scope two emissions, generated by the portfolio is the simplest carbon metric. If a fund owns 1% of a company, then it will be responsible for 1% of its total CO2 emissions, or its scope one and scope two CO2 emissions. The carbon footprint is then calculated by adding up the fund share of the CO2 emissions of all the companies in the fund. The main problem with this measure is it's difficult to compare the carbon footprint of funds or portfolios of different sizes. A better measure and more frequently used measure is carbon intensity of companies. Broadly speaking, it's a measure of the carbon emissions of the company expressed relative to the company output usually measured in revenues. To calculate portfolio carbon intensity, we need to calculate the sum of each portfolio carbons emissions intensity proportional to the amount of stock held in the portfolio. Of course, to work this out, we not only need to know what the portfolio holdings are and their weights, we also need to obtain carbon emissions data on the companies in the portfolio. We also need to obtain the sample data for a benchmark or the peer group of funds. While several methods and sources of data exist, it's important that the method we choose to use for our fund is the same as the one used to calculate the metric for the benchmark or the peer group. We now look at an example of a simplified portfolio of just 10 stocks to see how carbon intensity for the fund is calculated. To be able to calculate the fund carbon intensity using the formula provided earlier, we need to know what the portfolio holdings are, their size or weights in the portfolio, and the carbon intensity of each company. The weight of each holding is multiplied by the carbon intensity of each holding. The products obtained are then summed together. The overall figure gives us the portfolio carbon intensity, and in our scenario, the figure is 123.4 tons of CO2 per million US dollars of sales. This figure can then be compared to that of a benchmark, other funds, or even its own history if we wish to monitor how the metric has evolved over time. We can also obtain an overall ESG rating usually split into E,S and G components of the fund by looking at the holdings and the ESG score of each holding. The first task is to choose a scoring or rating system to capture ESG risks and potentially also ESG opportunities. For example, it could be a score out of 100 where a high score is a positive attribute. We also need to choose an external third-party data provider or develop an in-house company scoring system. The ratings or scores for each holding in the fund need to be obtained, which may pose a challenge but not all scores for all companies in the fund may be available. The individual company ESG scores are then multiplied by the security weighting. Lastly, the overall portfolio scores are calculated by adding up all the individual components, in this case the products of the weights and the scores. So what do we then do with this information? While using the scores, the fund can then be compared to other funds. We can also compare this score to that of a relevant benchmark. Of course, the results will be affected by the scoring system used. There are many databases and methodologies that give scores to individual companies, and there are also many different results that you can obtain depending on which database is used. Comparisons between funds therefore need to be made very carefully.
