On June 20, 2019, MSCI Inc. (“MSCI”) announced the expansion of its suite of indexes for institutional investors and wealth managers with the introduction of new indexes specifically focused on climate (the “Climate Indexes”).

Private companies and regulatory agencies are becoming increasingly attentive to the potential impacts that climate change may have on their business and the financial markets more generally. MSCI indicates that its Climate Indexes are intended to identify and measure financial risks and opportunities associated with climate change and facilitate decision making for institutional investors specifically seeking to limit their portfolios’ exposure to climate change risks.

Environmental, Social and Governance & Climate Issues

MSCI’s investment decision support tools and risk management services cater to institutional investors and wealth managers seeking access to targeted data to improve their portfolio analysis and make informed investment decisions.

MSCI’s Climate Indexes expand upon their existing “in-depth research, ratings and analysis of the environmental, social and governance [(“ESG”)]-related business practices of thousands of companies worldwide.” ESG considerations address a holistic combination of metrics seeking to quantify companies’ performance through addressing labor and employment, natural resources and sustainability, climate change, governance and board representation, and stakeholder engagement and reputational issues, among many others.

MSCI Climate Index

Within the broader ESG context, MSCI states that its Climate Indexes are intended to provide the data and metrics needed to help institutional investors build more climate resilient portfolios and integrate climate risk considerations in their equity investment decisions.

As stated in their recent press release, MSCI’s climate indexes aim to: (i) encourage investment in companies advancing climate change mitigation or adaptation goals (such as clean technology companies), (ii) discourage investment in companies with potentially significant stranded assets (such as extractive companies with assets that may lose value due to societal or regulatory pressures), (iii) broaden the scope of industries analyzed1 and (iv) improve customer usability to facilitate the index’s incorporation into a clients’ existing ESG strategy.

MSCI Climate Index Methodology

Each security within MSCI’s new Climate Indexes is measured through a three-step process, resulting in the re-calibration of MSCI’s historical measurement of the securities within the context of a global transition to a low-carbon economy (“Low Carbon Transition,” or “LCT”). First, MSCI determines a “category tilt” score, which categorizes the stock within one of five LCT categories, as reflected in the chart below. Companies providing potential climate solutions receive the highest score, neutral companies and companies involved in operational transition or product transition are ranked in the middle, and companies with possible stranded assets receive the lowest score.

Source: Adapted from MSCI Climate Change Index Factsheet2

Second, MSCI determines the stock’s “relative tilt,” with a higher score provided to those companies within each category that are “relatively better at managing their climate-related risk compared to their peers” within the same category. Although not specific to the Climate Indexes, MSCI has previously calculated a security’s “tilt” by combining: (i) the security’s ESG rating by measuring the issuer’s ability to “manage key medium- to long-term risks and opportunities arising from ESG factors relative to industry peers” and (ii) the security’s ESG recent rating change, if any. For the Climate Indexes, the category tilt and relative tilt scores are multiplied to reach a “Combined Score” for each stock.

Finally, MSCI multiplies the Combined Score by the stock’s relative weight in the parent index to reach the stock’s “Security Weight.” MSCI uses this score to determine a company’s absolute exposure to, and management of, economically-relevant risks and opportunities related to the Low Carbon Transition. MSCI rebalances the indexes on a semi-annual basis.

MSCI has not publicly disclosed its methods for calculating “relative tilt” or the metrics used to assess risk management tools in peer-to-peer comparisons, although MSCI offers that its data and analysis is developed by a subsidiary, MSCI ESG Research LLC.

Implications of MSCI Climate Indexes

Companies will likely continue to face growing pressures from investors to assess their potential climate change risks and opportunities. Awareness of the proliferation of ESG-based investment tools such as the Climate Indexes may incentivize companies to address potential climate change impacts and establish stronger ESG policies.

However, it is unclear whether MSCI has access to the data needed to implement a methodology that provides an accurate reflection of the climate risks faced by a company, or whether their proposed formula has the sensitivity to measure nuances in each companies’ ESG approach. As the results of MSCI’s analyses are only available to their clients, and as the details of MSCI’s methodology are proprietary, it can be difficult for a company to determine how it may rank on such an index in comparison to its peers.

More transparency on how MSCI’s “relative tilt” score is calculated, inclusion of a “model” company example, or identification of specific steps a company could take to improve their score would allow companies to tailor their ESG and climate-specific policies and disclosures to the ratings agencies’ criteria. In turn, more detailed and consistent inputs would enhance the accuracy of MSCI’s analyses.

In the interim, proactive companies should be mindful of these drivers. Companies should seek guidance on strategies to evaluate their ESG and climate-specific information currently made available for consideration by rankings services and seek to understand the investment implications of portfolio analysis tools like the Climate Indexes.