ESG indices are seeing breakneck speed growth, with smaller providers growing in influence.
The fallout from the Adani crisis has put the spotlight on index providers. NGO Toxic Bonds Initiative wrote letters on 23 February to members of the Net Zero Service Providers Alliance – including MSCI, S&P Dow Jones Indices, Bloomberg Index Services and Morningstar Indexes – urging them to remove Adani Group bonds and all fellow coal companies from their mainstream indices unless they unequivocally halt coal expansion and adopt a publicly disclosed 1.5°C-aligned transition plan
The usual response to this call is that a mainstream index is designed to track the whole market, for better or for worse.
But, Nick Haines, Senior Campaign Manager at climate and social advocacy group SumOfUS, which is a partner of the Toxic Bonds Initiative argues that if just one company, Hindenburg Research, can cause Adani stock to go into market freefall after exposing alleged accounting fraud and stock manipulation, the “track the market“ argument falls apart very quickly.
“We saw overnight that index providers had to radically alter their weightings… If you scratch the surface, it doesn’t take much for those assumptions of tracking the market passively to come tumbling down.”
Only one index provider, MSCI, has responded to the Toxic Bonds Initiative letter, saying that as of 1 March Adani Group bonds are not represented in its corporate bond indices. S&P Dow Jones has acknowledged receipt of the letter, and has removed Adani Enterprises from its sustainability indices.
The growing availability of such sustainable-focused or ESG indices, is another rebuttal to calls for stocks in controversial sectors such as coal, or weapons, to be removed from mainstream indices – although campaigners argue the mainstream dominates the market, so should be the focus.
Rise of ESG indices
The Index Industry Association (IIA) finds that while in 2022 overall growth of indices was 4.43%, the number of ESG indexes globally grew 55% and surpassed 50,000 worldwide across asset classes for the first time.
Robert Iati, CEO Managing Director at Burton-Taylor International Consulting, tells ESG Investor that since 2013 the overall growth in revenue for non-ESG indices has been in negative at -5.5%, while for ESG indices it has grown 39% over the same time period.
In 2021, global ESG index revenue increased by 31.6% to US$271.7 million, up from US$206.7 million in 2020, according to Burton-Taylor research. To underscore the meteoric growth, global ESG revenue in 2013 totalled just US$21.8 million.
And it appears this revenue growth is in spite of modest pricing practices. New data from Substantive Research finds that while in the ESG ratings and data space, some firms are paying the same providers around six times more than peers, this pricing inconsistency isn’t replicated by vendors of ESG indices.
Mike Carrodus, CEO of Substantive Research, says: “With firms trying to jump over barriers to entry and competition, where there is considerable incumbent provider power, in the ESG indices space you are seeing firms pricing flexibly, consistently and more transparently. It’s not across the board, but I would say you see more consistent and standardised models in the challenger index world than in the challenger ratings world.”
Burton-Taylor’s research finds that new entrants, rather than the likes of MSCI, S&P Dow Jones or FTSE, are gobbling up much of the growing ESG indices market share. ‘Other’ smaller providers, mostly based in the Asia-Pacific region, took US$117 million or 43.4% of global ESG index revenue in 2021, followed by MSCI who took US$63 million or 23.2% of revenue.
This doesn’t surprise John Willis, Director of Research at Planet Tracker, who says incumbents like MSCI, which has a high reputation and “can’t afford a slip up”, are going to be much more careful about introducing new indices. “They are already making such a massive EBITA [profit] margin of 75% or more, they are probably going ‘why bother?’” Smaller players, like Solactive or Qontigo, are going to be nimbler and more open to customising indices, he says.
Robert Edwards, Director of ESG Product Management at Morningstar Indexes, agrees, saying a lot more innovation in the ESG index sector has come from smaller providers. “If you think about the [history of this] industry, the very dominant indices were market cap weighted. They have been around for a long time. This emerging ESG presence has really been a catalytic event which has opened doors for a provider like Morningstar who has a pretty rich subset of intellectual property to pull from the likes of [subsidiary] Sustainalytics to build off.”
Morningstar earned US$1 million in revenue from ESG indices in 2021 and had 6% of market share, according to Burton-Taylor Consulting.
Edwards says trends in ESG indices are toward climate change-focused products, and increasingly tackling deforestation. He’s also seeing clients wanting indices linked to ‘impact’, aligning with companies that are doing tangible good for society or the environment. He adds there is a bigger market in Europe for ESG indices, heightened by increased ESG regulation in this area.
Singapore-based Scientific Beta is amongst the smaller ‘other’ providers that dominate market share of ESG indices, alongside players such as Japan Exchange Group and US-based Cboe Global Markets.
Pathways to net zero
Erik Christiansen, ESG and Climate Investment Specialist at Scientific Beta, says the main trend it is seeing from clients is a move from low-carbon strategies towards transition or alignment strategies. “There is less focus on simply reducing a portfolio’s carbon footprint or climate risk exposure, and more focus on how investors can push companies to adopt pathways towards net zero emissions,” says Christiansen.
But Christiansen says many products using such terms – including some carrying the EU-regulated Paris Aligned Benchmark label – are extremely tightly anchored to plain vanilla cap-weighted market indices. “It is unlikely that you can radically change the economy if you invest in the economy as it is today,” he notes.
With its Climate Impact Consistent Indices, Scientific Beta has constructed indices where capital allocation decisions are entirely based on how well companies are doing in terms of climate change mitigation compared to their peers, ie leaders are consistently rewarded over time and laggards consistently penalised.
Willis from Planet Tracker predicts that specialist and smaller ESG index providers will start to go further in customisation such as above, which he says is a broader trend in the investment industry – pointing to large asset managers increasingly allowing clients to vote their own shares.
He adds investment managers could also capitalise on the customisation trend. “Clients who are increasingly going for separately managed accounts for their portfolio are getting pretty close to indexing,” he says, explaining that they could start to ask their investment manager to design a customised index too – though this may bring up regulatory problems.
As the ESG index space continues to flourish, fixed income – the focus of Toxic Bond Initiative’s Adani campaign – looks set to be the next big thing. Global ESG fixed income indices grew by 122.5% in 2021, according to Burton-Taylor’s research. Iati says: “In the most recent 18 months, equity markets have stumbled and the changing economic conditions favoured other asset classes, such as fixed income. As investors reduced their exposure to equity markets, their funds have sought a haven in fixed income.”
Haines from SumOfUs says it and other NGOs will be more focused on the fixed income world, including indices, as fossil fuel companies seek to fund expansion through the debt and corporate bond market, as projects increasingly struggle to get finance through bank lending or equity.
“Adani is a really good example of that large issuance of bonds. So we’ve been focused a lot on bondholders and you can’t do this without the role that index providers have played in a significant portion of the market. Exchange-traded funds asset managers do just track the market, so we’ve got to look at the decision makers in that process. The index providers design the methodologies for the indices, and they are the ones who are ultimately deciding to include or exclude different businesses in those indexes.”