The S&P/ASX 200 ESG Index was built to incorporate ESG and provide benchmark-like performance.

As the effects of climate change become more apparent and social justice issues fill headlines, sustainable investing—the practice of incorporating environmental, social, and governance (ESG) data into investments—is becoming more popular than ever. 

New benchmark indices embedding ESG factors and investment products tracking them have launched around the world, enabling this growth. 

In the first eight months of 2020 alone, assets in exchange-traded funds (ETFs) tracking ESG indices have nearly doubled, increasing from US$57 to US$106 billion globally (Source: S&P Dow Jones Indices LLC). 

In Australia, index providers, exchanges, and assets managers, seeing this megatrend unfold, are setting a foundation for local growth as well. 

In 2019, S&P Dow Jones Indices and the ASX collaborated to develop the S&P/ASX 200 ESG Index, a sustainable counterpart to Australia’s leading index. Following this, an ETF based on the index was launched as well. 

We expect that many new ESG indices and investment products like these will follow, but as the number of ESG benchmarks and investable products multiply, understanding of these tools needs to grow as well. 

ESG indices tend to be more intricate in their construction, using a variety of data inputs not found in standard indices. For this reason, it’s important for investors to be aware of the basic elements of ESG indices, how these indices are changing, and their relevance to Australia’s market.

Evolution of ESG Indices

Over the past 20 years, the role ESG indices have played for companies and investors has evolved, and, in turn, the methodologies behind ESG indices have transformed as well.

In 1999, when S&P Dow Jones Indices launched the Dow Jones Sustainability World Index, the first global ESG index, ESG indices were primarily instruments to highlight a relatively small set of companies leading in sustainability practices. 

In line with this purpose, ESG indices tended to be narrow, only comprising the top 10% or so of companies of the index selection universe, industry by industry. 

Though companies favored this approach, and certain high-conviction ESG investors saw opportunities in investing in products tracking these indices, other investors were not willing to take on the risks associated with holding only a small selection of companies.

In recent years, as more investors have desired to incorporate ESG data into their portfolios, index providers have built new broad market indices that incorporate an ESG-related methodology. 

More practical and less restrictive than their predecessors, these indices are designed to be more in line with the broad market in their risk/return profiles, looking to achieve this by retaining a much larger portion of the parent index’s original market capitalisation.

The S&P/ASX 200 ESG Index was built with this philosophy in mind: to incorporate ESG, thereby reflecting the values of sustainability investors, but also providing benchmark-like performance, as shown in Figure 1.

Figure 1: S&P/ASX 200 versus S&P/ASX 200 ESG Index Based on Hypothetical Back-Tested Data

Source: S&P Dow Jones Indices LLC. Data as of Sept. 18, 2020. Indices were rebased to 100 on Sept. 17, 2010. Index performance based on total return in AUD. The S&P/ASX 200 ESG Index was launched on July 6, 2020. All data prior to the launch date is hypothetical back-tested data.  Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Integrating ESG into the Index

Even though the S&P/ASX 200 ESG Index is benchmark-like in its construction, a lot is taking place under the bonnet to ensure the index meets the sustainability criteria for the ESG marketplace. The index was developed using a local index as a starting point, but it ultimately adheres to international sustainability standards.

An essential element of the index, which speaks to local needs and promotes transparency, is its connection with the S&P/ASX 200, a benchmark broadly understood and followed by Australian investors. The companies composing this index make up the foundation for the S&P/ASX 200 ESG Index.

Starting with the S&P/ASX 200 Index, several international ESG standards are applied.

First, “norms-based” and product-based exclusions are applied, meaning companies operating in ways counter to sustainable investors’ views are eliminated. This includes companies involved in a substantial way in:

• Thermal coal extraction and power generation;
• Tobacco production or sales; and 
• Creation or sales of controversial weapons, such as chemical and nuclear weapons.

Then, companies performing poorly relative to their global industry group peers either with respect to the United Nations Global Compact (UNGC) or with respect to their S&P DJI ESG Score are eliminated. 

In the case of the UNGC, the bottom 5% of companies globally according to their UNGC score, as calculated by Arabesque, are removed; further, those companies in the bottom 25% with respect to their S&P DJI ESG Score are excluded.

Finally, companies are ranked by their S&P DJI ESG Score and selected so that each industry group maintains, as of the annual rebalance, approximately 75% of the original market cap of each industry group. The result is a broad index containing 119 of the original 200 securities in the parent index, as of Sept. 21, 2020.

This process, which is typically undertaken once a year on the last business day of April, defines the portfolio of companies making up the S&P/ASX 200 ESG Index. 

Changes in membership of the S&P/ASX 200, from which the index constituents are drawn, special rebalances related to changes in the methodology, or companies becoming involved in major ESG controversies can alter the composition of the index between annual rebalances.

Applying global ESG standards to Australia

Investors familiar with the companies in the S&P/ASX 200 may recognise that while some of the screens noted previously have a relatively large impact on the index—like the thermal coal exclusion, which takes out BHP and five other major companies—other screens have less impact.

For example, the tobacco and controversial weapons screens currently impact no companies. If this is the case, then why keep these screens at all?

There are two reasons. First, the index is based on a methodology, which S&P Dow Jones Indices applies around the world, that reflects international standards and norms. 

When S&P DJI conducts consultations to alter its standard ESG methodology, as it did recently with respect to thermal coal, feedback was received from all major regions. This is appropriate in a global market in which commercial markets are highly connected and ESG issues, like climate change, cannot be confined to the borders of a single country.

Second, S&P DJI and ASX wanted to build an index that was “future proofed.” Though a company involved in controversial weapons is not now in the S&P/ASX 200, the index methodology is designed to ensure that if one emerged, the screen would be in place to apply to this company.

ESG benchmarks and investments: A bright future in Australia

For many countries around the world—including Australia—ESG issues are not abstract concepts, but are instead tangible issues that affect companies, institutions, communities, and individuals every day. This is leading to changes in choices people make regarding the food we eat, the transportation we take, and the energy we consume as we live. 

Though values may have previously played a lesser role in driving investment decisions, this appears to be a changing trend. 

Fortunately for investors, new benchmarks and investment products are emerging to enable their values not to remain compartmentalised to a few areas of their lives but can inform investment choices as well.

For more information: S&P DJI performance disclosure and general disclaimer.