Northern Trust Asset Management: Developing an NT ESG Vector Score

Northern Trust Asset Management believes that investors should be compensated for the risks they take - in all market environments and in any investment strategy. To help do so, Northern Trust has developed a comprehensive sustainable investment score. The Northern Trust ESG Vector Score™ is a measurement that assesses publicly traded companies in the context of financially relevant environmental, social and governance (ESG)-related criteria that could impact their operating performance.

The methodology is designed to capture both the magnitude and direction of potential ESG-related risks. It marries two leading sustainability reporting frameworks: the Sustainability Accounting Standards Board (SASB) Standards, which are industry-specific sustainability disclosure standards focused on financial materiality; and the thematic structure of the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD).

It applies TCFD’s framework on governance, strategy and risk management to all financially material ESG risks across the SASB Standards, resulting in a comprehensive risk assessment. While, as the name implies, the TCFD Recommendations are only focused on climate-related issues, we extended this approach to apply these concepts to all 26 financially material ESG risks across the SASB Standards, resulting in a more comprehensive risk assessment for each company. The score places a further emphasis on corporate governance because of the impact it can have on long-term value.

Why this approach?

As the demand for ESG investing has grown, so too has the number of data providers, each offering varying information, reporting components and levels of transparency. This has complicated investors’ efforts to assess the magnitude and direction of individual companies’ ESG-related issues.

Investors have expressed the need for a more transparent and disciplined framework that focuses only on the ESG-related business issues that could impact the financial condition of a company and ultimately their portfolios’ investment returns. Guided by SASB Standards, the NT ESG Vector scoring process identifies sustainability issues that are likely to affect the financial condition or operating performance of companies within a given industry.

For example, in a human capital-intensive industry such as air freight and logistics, how a company manages this ESG business issue can impact how well it performs. Regarding a company’s management of human capital, with respect to employee health and safety considerations, the Vector Score considers the following aspects:

• Historical view: How has the company managed employee safety programs and certifications? What is its employee injury rate?
• Peer view: How has the company performed relative to industry peers on health and safety issues?
• Forward view: Is the company located in a country with strict working standards? Is the company actively working to decrease the frequency of health and safety issues?

Across each industry’s applicable General Issue Categories (the material issue classification used by SASB), metrics are identified as either a primary or secondary indicator based on the potential impacts they might have on a given company within that specific industry.

Take as an example the water and wastewater management issue for a company within the meat, poultry and dairy industry. Primary indicators would include: effluent management; water intensity; water intensity trend; water risk management; and waste management programs. Secondary indicators would include: sustainable agriculture programs; and food and beverage sustainability initiatives.

These indicators are weighted, with higher weight given to the primary indicators, and averaged to arrive at an unadjusted score between 0-100.

A key aspect of any strong fundamental analysis of a company lies in its ability to formulate opinions on how the company is performing relative to its peers and how that company may perform in the future. The key to incorporating these important viewpoints – while ensuring transparency and consistency – was through the integration of the thematic structure established by the TCFD recommendations.

In a last step, a 20% weight is given to corporate governance metrics informed by best practices in: board of directors, ownership and shareholder rights; remuneration; financial reporting; and stakeholder governance.

What were the outcomes, benefits, challenges and next steps?

The key benefits of using the NT ESG Vector Score within our investment process are that it:

• Enables intentional and transparent integration of ESG considerations into investment processes, addressing the need for a consistent way to measure and report on ESG investments across equity and corporate fixed income;
• Provides a consistent, transparent methodology to gain greater clarity when building and managing sustainable portfolios by focusing on the magnitude and direction of key ESG-related business issues likely to have a financial impact on companies;
• Offers more precision in identifying ESG-related business risks that could impact performance, whether constructing portfolios using best-in-class security selection or exclusionary techniques; and
• Assists in prioritising corporate engagement, deepening the alignment of sustainable investments and stewardship, leading to more deliberate engagements and the ability to track progress over time with a consistent metric.

In addition to using the NT ESG Vector score for buy/sell decisions, we use the NT ESG Vector to inform our corporate engagements. This will help NTAM lead more deliberate engagements and track portfolio company progress. This approach supports NTAM’s application of the PRI’s Active Ownership 2.0 framework.

Since ESG reporting and requirements are continually maturing, NTAM designed the NT ESG Vector Score framework as open-architecture, providing flexibility to incorporate additional best-in-class data as it becomes available. This will enable it to support multiple data sources and new industry requirements over time.

In terms of challenges, data quality and availability are issues for the entire industry. A critical objective in building the NT ESG Vector Score was obtaining consistent and comparable data across the full universe of companies. NTAM undertook extensive due diligence to select high-quality inputs and data points.

The NT ESG Vector Score is immediately serving a variety of functions. The score is currently being leveraged to prioritize stewardship activities and is being applied to equity and corporate fixed income portfolios. It has underpinned the launch of a suite of sustainable ETFs in EMEA and another suite in North America that both incorporate the NT ESG Vector Score. NTAM is continuing to explore the various ways it can leverage the NT ESG Vector Score to strengthen its offering and meet the needs of investors. The firm intends to use the score to achieve synergies between its ESG investment process integration, stewardship and product strategy.