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Investing often relates to how we categorize risk. Environmental, social, and governance (ESG) is a lens we can use to do just that. The bottom line is ESG risks are financial risks, but how do decisions made by companies impact shareholders and investors? To talk about how the ESG lens is used to classify risk bands, Tony was joined by Cyrus Lotfipour, CFA, Executive Director, ESG Research at MSCI, Inc., who is responsible for the innovation and development of its ESG ratings methodology.

This podcast discusses ESG investing generally and does not represent any methodology used by Wilmington Trust in evaluation of proprietary or third-party ESG products. Wilmington Trust uses data provided by MSCI as part of its methodology in evaluating environmental, social and governance factors of a particular investment.

There is no guarantee that integrating environmental, social, or governance (ESG) analysis will provide improved risk-adjusted returns over any specific time period. The evaluation of ESG factors will affect the strategy’s exposure to certain issuers, industries, sectors, regions, and countries and may impact the relative financial performance of the strategy depending on whether such investments are in or out of favor.

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Financial Risk Viewed Through an ESG Lens

Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors

Cyrus Lotfipour, CFA®, Executive Director, ESG Research, MSCI, Inc.

Tony Roth: This is Tony Roth and you are listening to Wilmington Trust's Capital Considerations. Today we have a really fascinating topic, I think that has been in the news on a fairly prevalent basis, which is the topic of environmental, social, and governance investing, so-called ESG investing. It has raised a certain level of attention, and frankly controversy, around whether or not it's the right kind of thing for public institutions to be doing with their assets.

Investing in this, if you will, values-based methodology or values-oriented type of investing that may reflect the values of one part of the political constituency, but not necessarily all of the political constituency. It's also come under some level of fire because there's some misunderstanding around what ESG actually does as a method of investing and whether or not it sort of accomplishes what many people's perceptions think it’s designed to accomplish.

So, we're going to get into some of these issues today and we are very fortunate to have Cyrus Lotfipour with us. Cyrus is the head of ESG models and research and development for MSCI for their ESG research vertical. He leads the global team that is responsible for the development and maintenance of the ESG ratings methodology.

And prior to his current role, Cyrus led the North American ESG ratings. And was the sector lead for chemicals and capital goods research at MSCI ESG Research. I want to say that we're very excited to have you because MSCI and their ESG group, which you head, is in our view, the leader within the industry of providing analytics on companies relative to their, their ESG attributes.

So, thank you so much for joining here. And what is, I think, a touchy set of


Cyrus Lotfipour: Well, thanks for having me, and I'm looking forward to touch on these touchy subjects.

Tony Roth: Yes, and I want to say at the outset that Wilmington Trust is non-partisan. We may take a stance, but it won't be a political stance, so we don't mean to offend anybody's political sensibilities at all.

So I think the place to start, environmental, social, and governance, let's just spend a brief moment on each of those when we consider the environmental, social, and governance reality of a company. The impact of a company, the fact that a company has effects on the world in an environmental domain, in the social domain.

What do we mean by all that?

Cyrus Lotfipour: ESG I think is somewhat of a convenient lens to view and categorize externalities that companies generate on society. And those externalities come with societal impacts, and sometimes those societal impacts, um, relate to topics like climate change and sometimes they're related to how a company has impacts on employees or local communities, or its shareholders for that matter. Ultimately, much of investing relates to how do we categorize risks. ESG is one way of categorizing those types of risks that might go underappreciated without that specific lens.

Tony Roth: Let’s take for example, Tesla. And we're not trying to pick on Tesla nor are we trying to praise Tesla without conducting a comprehensive analysis.

There's probably a perception from the layperson that Tesla would get a good rating on the E of ESG, because Tesla sells electric vehicles, which are supposed to be environmentally friendly, and so by not emitting hydrocarbons at the point of, um, usage, Tesla would be a, a good company from an ESG standpoint.

Just in terms of the E. So far so good?

Cyrus Lotfipour: So far so good. You got it.

Tony Roth: Now, I know also, there's been a lot of noise around Tesla as it relates to governance, whether or not it's a well governed company, whether there's a diverse board of directors from a social standpoint, whether Tesla has treated its employees well.

As a matter of fact, the S&P, I believe, has removed Tesla from its index of ESG-preferred companies because even though if one were to even assume that the E or the environmental impact was positive, that it's not a good citizen from a social and/or governance standpoint. So, there are whole range of perspectives that need to be brought to bear to a company to understand what is totally SG effectives, if you will.

Cyrus Lotfipour: With a categorization of ESG, as I was mentioning, it does encompass a lot of different types of categories from climate change to product liability to governance. And sometimes there are going to be positive correlations between those issues, sometimes there'll be negative correlations, but at the end of the day there's always going to be tradeoffs that companies have on society or that investors experience with their investments in these companies.

And Tesla's a great example of these tradeoffs. One aspect that a company does really well on, such as mitigating its impact on climate by providing an alternative to combustion engines, is it obviously a net positive. And Tesla does do quite well on what we would define as our climate change theme, which is a really a key characteristic of how we rate companies like Tesla.

On the other end of that spectrum is governance and product liability issues. So, without diving into the specifics of those companies’ cases, we acknowledge that there are tradeoffs to these kinds of companies. And with the ESG framework, one thing that MSCI ESG ratings really tries to do is come to that appropriate waiting mechanism for how you weight certain topics that are material to investors, in particular.

However, if you were to look at the topics that are relevant to society at large, you might come to a totally different view of what, what should be that appropriate weighting of ESG issues. There's tradeoffs to everything, but depending on the lens that you're looking to apply on a company, whether or not you're focused on the company's impact on society is going to lead to a very different weighting between these ESG issues, then if you're focused on the societal impact on a company. That is, it has a potentially financially material impact on shareholder returns.

Tony Roth: Okay, we're getting to the heart very quickly here of an important distinction, which is this idea that companies can, on the one hand, have an impact for investors or shareholders when we evaluate their ESG reality that's different than their impact on the planet, society, civilizations.

When we think about Tesla and just focusing on the E, the environmental, what does that mean when you talk about the financial materiality of their environmental footprint?

Cyrus Lotfipour: What's important to qualify here with how we view Tesla is not a Tesla-specific methodology.

It's a methodology that's steeped in industry-based rules and standards, and so the way in which we determine which issues are potentially financially relevant to a given company starts out with an industry basis. With the automobiles industry we've assigned four distinct environmental and social key issues that are relevant to companies in the automobiles industry.

And this is your typical automobile manufacturer in addition to our, our evaluation of governance, which is something that we believe is universally applicable to every company that we evaluate. Those issues, we've determined to be financially relevant, doesn't necessarily mean that they don't have an impact on society.

It's just that of the impacts that a company has on society, there’s a subset of those that have an impact on society and also have an impact on shareholders and investors. It's that subset that ESG is focused on. And I think, I want to be really clear there has been a lot of, I think, conflation about what ESG is and what is it not.

ESG risks are financial risks. It's about internalizing those costs of externalities that companies have on society and the degree and likelihood that those external costs are actually going to come down and have an implication on shareholders.

Tony Roth: So, give me an example in the case of Tesla. Again, just looking at its environmental consequences or it's environmental reality, what would be an example of a financial consideration or factor?

Cyrus Lotfipour: Well, one factor that we would look into, particularly for the automobile sector, is what types of products they're producing. The reason we look at a company's carbon footprint, particularly in automobile manufacturers, probably I think I would boil it down to two potential transmission channels. One is regulatory impact is that we know that companies can be fined for not, abiding by the fuel economy standards set by regulators.

We also acknowledge that there's a greater demand for electric vehicles. Of course, there are nuances, but generally speaking, those are the two reasons that we look at a company's vehicle portfolio. And in the case of Tesla as a manufacturer of electric vehicles, they score very well .

That is something that really does improve their environmental profile relative to say, non-EV manufacturers in the same sector.

Tony Roth: What if we talk, for example, Cyrus, Ford. And let's just assume that Ford only had one vehicle that it sold, which was the Ford F-150, the regular gas guzzling Ford F-150.

Let's assume that they've managed to get that car to a place where it's just above the regulatory requirements for fuel economy. Would that get the same score as Tesla? Because there's tremendous demand for the F-150. It satisfies the regulatory hurdle in my hypothetical for our fuel economy standards,

Cyrus Lotfipour: Society at large holds companies to a higher standard than just whether or not they happen to produce a token automobile that has positive environmental attributes.

The way we evaluate ESG rating, is more of a holistic view at a company's level. What is a company's total sales comprised of? For Tesla it's a hundred percent of their sales are dedicated to these environmentally beneficial attributes. In Ford. It's not zero, but it's not a hundred percent.

So, those are ways in which we have to differentiate between the degree to which these types of technologies represent a core strategy of the company. And it might be that Ford and other competitors in the automobiles industry are investing comparable amounts in their electric vehicle fleets.

It's committing to emissions reduction targets, um, having adequate governance to ensure that their strategy is implemented effectively. But when it comes down to it at the end of the day, and we look at their product portfolio. In summary, Ford may not necessarily have as strong of a product portfolio from a carbon emissions perspective as Tesla.

However, it's always about tradeoffs. What might become a positive for Tesla might also translate into a negative for Ford. But where Ford has an advantage, might be on another key issue that Tesla performs not as well on. Say, product liability issues, for example, or labor management issues.

Tony Roth: The demand for Tesla's vehicles is much higher than for ford vehicles to the, to the point where there's backlog for Tesla. So that would benefit Tesla and their ESG rating because they're doing something that has a very positive demand that's also good for the environment. Is that fair?

Cyrus Lotfipour: Setting aside demand specifically and how we quantify demand, let’s look at just their production volumes of electric vehicles. And we say Tesla has a higher production volume of electric vehicles, thus Tesla has a product portfolio that is better positioned to transition to a low carbon economy. And that is what we're saying when we categorize Tesla as having a better environmental pillar score than say Ford. 

Tony Roth: But you're making an assumption that it's good to have a low carbon economy.

If everything is about financial materiality, isn't there a value assumption at the base of this independent of profit, if you will, it's better to have a profit that promotes a better environment than a profit that doesn't promote a better environment. Isn't that value there or not?

Cyrus Lotfipour: It is there. Absolutely. And that is the reason we do make that implicit assumption that the transition to a low carbon economy and companies’ abilities to align their product portfolios with that transition does produce financial benefits and mitigates the financial risk in the future. There are either risks and or potential opportunities that are arise.

I mean, take an oil own gas company, for example. Their transition profile is primarily going to be dictated in terms of how they’ve identified a strategy to reduce their reliance on, say, fossil fuels and maybe invest in alternatives. Whereas an electric equipment manufacturer isn't necessarily going to face a significant degree of transition of risk, but might actually derive significant opportunity from, say, producing wind turbines or solar panels. This risk and opportunity equation can come in many different forms, but it all relies on the assumption that there's a financial benefit to aligning with a transition to a low carbon economy.

Tony Roth: Let’s then, therefore, conclude the Tesla gets a good score because clearly all these vehicles they're selling are going to promote a climate result that doesn't have as many emissions and won't contribute to global warming the same way that a comparative gasoline vehicle would. What about the fact that if you go all the way up the supply chain, let's just posit, it whether it's true or not, that in order for Tesla to build their cars, they have to pull a lot of lithium out of the ground.

And let's assume that while that has no real bearing on climate change, as such, it has a lot of other negative externalities on the environment. It may have other negative externalities on the communities in which this lithium is pulled out of the ground on the workers that do it, et cetera. But let's ignore that for a moment.

Let's just think about the environment and let's assume that by pulling all this lithium out of the ground, it results in a lot of harm to the environment, um, in all the various areas of the world where this lithium mining is occurring. Is that something that you guys take into account or is that something that's essentially ignored because it's not under today's world of regulation, financially material to the end result of Tesla.

Cyrus Lotfipour: It's not ignored, but it is not a key part of our industry framework for how we evaluate Tesla. Just as a reminder, the way we set these issues is really starting out at identifying where a company's externalities lie, and that is potentially one externality of being reliant on rare earth minerals. You have to get the minerals out of the ground, and sometimes they can be mined in areas with maybe substandard working conditions.

Companies generate externalities all across the ESG board, but not all of those externalities are going to necessarily result in a financially relevant impact to the company. In the case of the automobiles industry, these types of impacts have not been necessarily identified as being financially materials to the company, albeit they might be, material to an individual stakeholder that's affected by those mining operations.

That being said, there's also supply constraints that we have to consider. So, if Tesla or another manufacturer were to be implicated in, say, severe human rights abuses stemming from its operations and its supply chain, that would be when it becomes a potentially financial material issue for a automobile manufacturer like Tesla.

So there is room to make these kind of company specific adjustments to account for these somewhat nuances that exist based on the business model that a certain company adopts like Tesla.

Tony Roth: I think a really important distinction in how ESG operates relative to how I'm going to suggest many investors might have expected it to operate, which is that the goal of the ESG ranking essentially, particularly as it relates to an environment, is to give the company a score based on how well it's promoting some of these foundational values, like helping the environment, fair equality, when it comes to governance, et cetera, but does so in a way that looks at these financially material factors.

And if you have a situation, like a Tesla, for example, and let's just say that somewhere up the supply chain in order to get some of the materials that go into the electrical vehicle there are activities that you may observe, but don't believe the ecosystem around Tesla, whether it be regulatory, whether it be media, whether it be other stakeholders are particularly tuned into and don't see any important risk that it's going to impact the company.

Then those factors are not likely to make it into the waiting system for that particular company

Cyrus Lotfipour: The way in which we approach this waiting system for companies is very systematic, and so it does begin with that industry layer, starting with their impacts that they generate in society, identifying through a framework whether or not those impacts on an industry level have a financially material bearing on a company, and then of course, making room for nuances that exist at a company-specific or regional level.

Because we acknowledge, say for instance, water stress is one great example in which no matter what a user of water is going to be taking water from a local resource. But depending on where that local resource is, that whether it's a scarce resource or a not scarce resource. That is potentially going to have either a greater impact on society and also potential greater likelihood of it resulting in a repercussion on a company's operating integrity.

So there are those kinds of nuances that we also have to consider beyond just the type of products that a company produces, and also look into the specific geographies that a company is operating in.

Tony Roth: We started with a, this distinction that, that you made, Cyrus, that I'm trying to sort of sharpen our focus on, which is that the whole force of ESG today is to find those financially material factors as it relates to those underlying values that are trying to be promoted, so environmental, social and governance.

We know that there are lots of factors that might actually in some direct way bear on those underlying values, but they're not being taken into account because the likelihood of them becoming financially material to those various constituencies. To the company, given the ecosystem that company exists in, I is not very high.

Cyrus Lotfipour: That's absolutely right. With ESG ratings focus as a financially relevant indicator, non-financially relevant indicators are not going to be making it into our final assessment,

Tony Roth: They might actually be in fact. Very relevant from an externality standpoint to the world. Even though they may be relevant, they're not going to be taken into account if they're not financially material to the balance sheet of the company, essentially.

Cyrus Lotfipour: Right. And I think one of the challenges that we've had to navigate is the fact that different investors have different views on what societal impact should be valued most. And that's where we get into a degree of subjectivity. We’re going to see a wide range of responses if we were to ask a hundred different investors that have ESG strategies which of these societal impacts they care about most and rank them everybody's going to come up with a different answer there.

We acknowledge that there is a higher degree of subjectivity there, and also it provides us with an opportunity to solutions that are tailored to individual investor objectives because at the end of the day, we're trying to provide investment decision support tools that are tailored to an individual investor's use case.

Cyrus Lotfipour: That might be taking our off the shelf solution for financially relevant ESG ratings or it might be taking, an a la cart to tailor their own solution that fits their own values.

Tony Roth: It's not easy to say what the values are of the average person. But I think what we have found as a consumer of the work that your team does is that there can be a gap between the rating that's reflected by MSCI in its ESG data, which is essentially based on financial materiality to the balance sheet of the company and what the average person would care about, but the ecosystem around the companies do a fairly good job of keeping things fairly close.

If I were to go out and look at a Tesla or any one of a number of companies and really drill into what your ESG rating for that company was based on, ultimately the financial materiality criterion, I think what I find is. It might be a little different than what I would focus on.

There may be some things that aren't financially material, some externalities that that company might have, but I think you guys keep it fairly close, and that's what our analysts believe. I wanted to talk about one particular example that I think is really critical as we move forward, which is the idea of carbon emissions.

And one of the frameworks that is been talked a lot about is the idea of these scope emissions, scope one, scope two, and scope three. And the reason I think it's so important is because when we think about climate change it's primarily based on global warming. And global warming is primarily based on emissions.

And emissions are primarily based on carbon dioxide, although there are some other gases that play a role. And here's the key part. In order for a company, like MSCI to say, well, we want to look at all of the various ways in which the activity of a company leads to harmful emissions in the environment, you have to have access to data that tells you that today. We don't have an environment in a framework or an ecosystem in which companies are, are really required to rigorously report what their emissions are through a system like Scope one, two, and three. I wanted to ask you, Cyrus, could you first give us a very quick understanding of what the Scope one, two, and three is, and then talk about if every company had a reliable set of data that told you what is scope one through three emissions were, how might that affect the kinds of information that you could provide to clients?

Cyrus Lotfipour: Let's start off with the basics. So scope one emissions. Those are the emissions that are generated directly by a company's operations. So I think a steel manufacturer producing steel.

The emissions generated from that steel production process. Is it Scope one? Scope two emissions are the emissions generated through its use of electricity or other external energy sources. So, the emissions associated with, say, the power generator use as the supplier of electricity and Scope three is really where it becomes much more complicated.

It's really anything that's beyond a company's direct operations. And this electricity use, uh, this includes its supply-chain emissions and it's also its end product usage by, um, by its customers.

Tony Roth: So, in the case of Tesla, It is possible, I'm not saying this is based on anything in reality, but it could be possible that the energy, that goes into extracting lithium from the ground to make Tesla batteries could be even greater a degree of energy that goes into making the cars. That is a Scope three emission that happens before Tesla even buys lithium somewhere else in the world by some other company.

Cyrus Lotfipour: Exactly. So it's included both its supply chain and obviously Tesla does pretty well with its end-product usage because it’s vehicles don't produce as many emissions as, say, a company that's predominantly combustion engine focused.

But I think one of the biggest challenges in scope three is just how much it encompasses. I'm not making this up. This is MSCI’s view. We take this from the standard setters. This is particularly from the Greenhouse Gas Emissions Protocol, which has set that there are 15 categories within this Scope three category.

And so because of that degree of complexity, we also see that there's a greater inconsistency in how companies are actually reporting their emissions of Scope three. And I think that gets the second point of your, of your question, that if we were to have a standard and a perfect data set, what would we do with it?

I think it's important for us to understand why we don't have a perfect data set. And you know, this is something that the ESG world has been grappling with since its inception, which is challenges around data quality, challenges around the consistency of it, and also the degree to which it's mandated by regulators is, I think, going to be one of the most pressing issues that we come across in the next couple of years.

For Scope three emissions in particular, it's actually taken on a lot more, I think, attention within the us uh, than other ESG issues. The SEC recently put out a proposal, this was, last year, uh, specifically asking for feedback on, mandating Scope three emissions reporting. One of the reasons they are proposing that is just acknowledging the degree of inconsistency that exists within Scope three reporting. Approximately one-third of U.S. companies today report Scope one and Scope two emissions. But only around 15% report their Scope three emissions. And of the 15% that's reporting their Scope three, it's probably a much smaller portion that is fully reporting their Scope three emissions. So in certain cases, they might only provide reporting on their emissions associated with their employee travel, which might be a drop in the bucket compared to their supply-chain emissions or their product usage emissions.

Ultimately, we want to see a proposal that results in the greatest uniformity in how companies are reporting their scope three emissions. Scope three emissions are really prone to methodological inconsistencies, cause at the end of the day, companies use input output models, life cycle assessments, and the quality and variation in those models can contribute to sometimes significant volatility in their company's own estimates.

That's a real caveat that we acknowledge going into it and think. Our regulatory view on the accounting of these emissions will really help investors in the future.

Tony Roth: So when you talked about materiality and the last time you used that word, Cyrus, you were not talking about financial materiality to today's balance sheet.

You were talking about the environmental materiality of the Scope three emissions, correct?

Cyrus Lotfipour:  Well this is actually on the language used by the SEC, we would have to look at the specifics of how that language is used. But materiality was without the precursor of financial, but whether or not it's material to be decision to disclose those emissions.

Tony Roth: A lot of our clients will come in and they'll say to us, gee, we want to invest in ESG. We're willing to maybe even take a very modest amount of compromise on returns for helping the environment. Not everyone wants to do that by any means, but some people might. We want to know that the method that we're pursuing is the method that we're think we're pursuing, which is that we're really taking into account in a very fulsome way, the externalities that company activities and products and services actually have on the environment.

One of the reasons that we don't have that today in all aspects, in all respects, is because the ecosystem focuses on financial materiality. That's what most of the street wants. They want to know what is the potential impact of a company to their bottom line if they behave in a certain way or don't behave in a certain way.

And that's essentially what MSCI is doing with its ESG ratings. But another reason is that there are externalities that the research providers like MSCI, as the leading research provider, are not in a position to even collect assessments of because the research, the data doesn't exist. And so if we had a federal regulatory environment where companies were in fact required to report on, not just Scope one, two, but, and scope three in some acceptably consistent and high quality way, then it may be that investors, um, and other players in the ecosystem might penalize companies as investors, um, that don't have good scores relative to whatever the standard may be. And in that case, MSCI would probably start to incorporate these so-called broader externalities because it would become financially, material by way of investor behavior.

And so it all starts with having good data on externalities in the first place, which can only come from standards and regulations within the industry and within the government.

Cyrus Lotfipour: I guess my main comment there is, is that we're not holding our breath. We’re forging ahead without mandatory disclosures, without the leadership, sometimes of government to come to a consensus on how ESG data should or should not be disclosed.

And we also know that there's going to be significant discrepancies between what the U.S. landscape turns out to be versus what the European landscape is. So we have today, and we acknowledge that this is going to continue to exist, a substantial discrepancy in the reporting standards across regions.

That's our starting point. We are not just U.S.-focused, and so we acknowledge that there are discrepancies and so we have to fill those gaps with our own models wherever possible. And we do have a very comprehensive Scope three estimation model to help us overcome those challenges and not wait on regulators to produce a landscape that requires companies to uniformly report. And it's not just Scope three emissions, it's really anywhere within the ESG data landscape where reporting is lacking and we have to fill the holes with a mosaic of alternative data sources.

Tony Roth: But in many of these cases, if the foundational reporting doesn't exist, we'll call it primary reporting, it's far less likely to be financially material.

It's, it's much less likely that investors, regulators, analysts are going to penalize companies for not doing as well in these areas if companies aren't required to provide data in a consistent, high-quality way. So, you may decide to go out and plug some of those holes, but your incentive to do so, if your criterion is financial materiality, is probably not that great because a lot of this additional information may not be particularly material from a financial standpoint to these companies.

Cyrus Lotfipour: I would disagree with that—let's take the fossil fuel industry as an example. If we were to take one major contributor to climate change, we would probably target the fossil fuel industry as one of the chief culprits. It's both a large impact on society and also potentially a large financially material impact to the companies with the transition to low carbon economy. I wouldn't say that fossil fuel industry is a beacon of disclosure right now with uniformity, but I think analysts and the investment community acknowledge that their product portfolio is one that is highly carbon emissions intensive. Even though we're not getting that disclosure directly from the companies, we know what their products are, we know where their reserves are located, and we know what types of reserves they have.

We do need to fill that gap where possible. Even if companies are not necessarily reporting it today, I don't necessarily think that's an indication of the degree of materiality it has in the future,

Tony Roth: But certainly there are lots of industries that have lots of externalities that they're not reporting on those externalities, and you guys are not spending the majority of your time trying to run around and find externalities that aren't really being appreciated by the overall reporting and regulatory and, and financial analyst ecosystem.

Cyrus Lotfipour: Within the ESG ratings framework, yes, I would say that's probably true. The ESG ratings framework does focus on a selection of the e sg issues that are most relevant. But in terms of like the broader data that is actually provided to investors, we do want to make sure that the right information is tailored to the individual investors' use case, whether or not it's about the types of weapons they're producing that might not necessarily have a financially material impact on the company but it does potentially misalign with the values of certain investors. Or tobacco production or any other values-based involvement that might not necessarily be a financially material impact to the company, but to which it really matters for certain values-based investors.

Tony Roth: That's a good example. The weapons example.

You might go to an American weapons contractor and they may create a particular weapon that certain actors in the overall environment today may be using to unduly target civilians. And it may be that there's no way to incorporate that into your ESG system because it really doesn't have any financial materiality.

No one's penalizing them for it, no one's really paying much attention to it per se, except for a very small group of activists, perhaps. It's not finding its way into your ESG framework. But on the other hand, if a particular client were to come to you and say, listen, I've got the means I want to invest in ways that don't have these types of weapons, where companies are penalized for creating these kinds of weapons.

You could create something custom for them. You have the ability to do it even though it's not in the baseline.

Cyrus Lotfipour:  Not only would we create something custom, but we would also offer them an off-the-shelf solution that says, here's a framework for you to view your client’s values. And here is a set of criteria that you can use to implement that framework that specifically cuts out weapons that are described as being indiscriminate or particularly misaligned with international weapons conventions.

That is the solution that we do provide off the shelf. And sometimes there are custom needs. But many cases, the frameworks that we offer off the shelf are ones that generally cover the most commonly used values, alignment criteria.

Tony Roth: And where are things heading in the broader picture? For example, instances of values that might not have been in the core frameworks three or five years ago.

Do they tend to find their way into the frameworks over time? If they're legitimate externalities due to awareness, increasing public pressure, evolution of regulatory standards, et cetera.

Cyrus Lotfipour: ESG is just going to continue to evolve. And we've, we've seen it evolve and our framework has evolved over the past 15 years to take into account the fact that ESG impacts are not static.

The ESG framework that we adopt on the industry basis is reviewed annually. It's a consultative approach that we take with our clients to consult with them and solicit feedback on changes to what we define as material to a given industry. And we've seen the have been substantial changes over the past 10 years alone.

Let's take privacy and data security issues. When I was an analyst 10 years ago, that wasn't necessarily a thing that was on our radar as much as it as it is today. Fast forward to today, and it's a highly regulated issue that companies need to take into account with regards to how they protect consumer data.

Either from breaches or from commercial misuse. So, we are going to continue to see that evolve over time and we're probably going to see issues like climate change become more financially material over time as well. And our framework is meant to adjust and evolve alongside ESG issues as they evolve as well.

Tony Roth: Well, that's very reassuring and important to understand. If we could just take a few more minutes, I do think it's important to address and distinguish the conversation we've just had around the gap between the overall set of externalities that a company in a perfect world could be measured to have versus what's actually being reported in the ESG framework based on financial materiality.

And I think the takeaway there is that the gap is not as great as perhaps. Certain more vocal participants in the industry have made it out to be in recent press, in our view. And I know that you agree with that. But I want to distinguish that from the other and probably larger set of topics that have, has received attention in the press, which is this idea that in a public setting where you're dealing with public funds, whether it be schools, whether it be public pensions, et cetera, There's been a real movement against ESG investing, and I think that that is predicated on the idea that ESG itself is pursuing the agenda of the underlying values of sort of one set of society, one set of constituents values that are, if you will, tuned into the environment, tuned into community equity, tuned into diversity and such.

Those are not necessarily appropriate values to be incorporating into the investment framework of public funds, because those public funds represent really all participants in, in that community, and not all participants really ascribe to those values. So, there's two sides to that argument.

If I frame it that way, it sort of feels like either side could be legitimate, perhaps. I just wanted to give you an opportunity to speak to that debate that's happening because, in fact, that's the debate that's probably receiving more attention than our first conversation, which I happen to think is more important over the long term.

But Cyrus, do you have any thoughts to, to add to the second debate that's happening?

Cyrus Lotfipour: ESG risks are purely about financial risks, and I think part of the debate that we are seeing in the public sphere right now is really around the conflation or lack of understanding about where ESG risks are situated.

I think if we were to have this exact same conversation in the public sphere about what ESG risks actually are there wouldn't necessarily be as much confusion about the equation between values alignment and financial materiality. Yes, there is a place for investors that want to align their portfolios with their values, but there is also a place for integrating ESG risks that are financially material to a accompanies operations.

Tony Roth: One of the chief concerns of those that have criticized the deployment of E S G and public portfolios is that it risks direct and capital away from what I'm going to describe as older economy hydrocarbon-based companies, and I'm sure there are other kinds of applications of these fights, but that's probably the predominant one, where that is not necessarily an outcome that everybody in that community would wish to see happen.

If I understand correctly, what you're saying is No. No. Even though those older economy oil companies, fracking companies gas companies, et cetera, may be inherently involved in hydrocarbons in a much more direct way, ESG doesn't necessarily have to penalize them if they're making the right kind of progress or they're doing the right kinds of things within the framework of their industry.

They could actually receive a favorable ESG score. Is that fair?

Cyrus Lotfipour: And it's not only that. I think one important thing to remember here is that the ESG rating is an industry-relative rating. So within the oil and gas industry, there is going to be a best-in-class company and a worst-in-class company.

That's just set by the definition of how we define an ESG rating. Climate considerations are one piece of the puzzle. As with the Tesla case, we acknowledge that there are tradeoffs, but governance is also a very large piece of the equation. And I think we'd be hard pressed to find a group of investors who don't think that having an independent board is an important attribute of a good, well-governed company.

The tradeoff equation and also this industry-relative piece that I think is really important to take into consideration, especially as we're evaluating the financial risks of these ESG issues.

Tony Roth: Well, we're certainly not going to be able to settle all these questions here today, but I do think that having these two key takeaways, the first being that while ESG does not purport to and certainly does not capture all of the externalities the companies have on the environment or in their communities, it does a pretty good job of it, and it's getting better all the time. As the overall ecosystem learns of new challenges, the companies are presenting for the environment or their communities and eventually they find their way into that equation of financial materiality, and I think that's Scope one, two, and three.

If and when they become mandated. That'll be a really important example of that. Also finding its way in. That's the first takeaway. And the second takeaway, I would say is that there's a lot of noise and concern around the use of ESG and the incorporation of ESG for public monies. I think that there's probably a lot of misunderstanding around what those metrics actually mean for investing those public funds into different industries.

While I'm not prepared to say exactly what that impact is, it's probably not the stark impact that most people think, i.e., you can't ever invest in an oil company again, or a hydrocarbon-related company versus investing in green companies like wind and solar power, et cetera. So that's something that needs to be, I think, explored and appreciated deeply and not just on the surface before significant positions are staked out.

Cyrus, this has been a, a really important conversation and I want to thank you again so much for being here today.

Cyrus Lotfipour: Thanks for having me. It's been a great conversation.

Tony Roth: I want to remind everybody that you can go to wilmingtontrust.com for a full roundup of our latest thinking on the economy and the markets.

Also, I would like to mention today that this episode will be the first, uh, in a second series that we're running this year on sustainable investing. So, thank you all again for joining us today. 


This podcast is for educational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or recommendation or determination that any investment strategy is suitable for a specific investor.

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Featured Guest

Cyrus Lotfipour, CFA
Executive Director, ESG Research
MSCI, Inc.

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