What Actually Is an ESG Index?

ESG stands for environmental, social, and corporate governance. A company’s CO₂ footprint, recycling management, human rights practices, and financial transparency are examples of important ESG aspects. ESG criteria are also used to rate sustainable investment products.

A stock index tracks the price performance of a basket of shares of companies assembled to represent a specific equity market or a certain segment of that market. To calculate the index, the companies can all be weighted equally or differently, for instance on the basis of their respective market capitalizations. The index itself is not an investment product, but instead serves as an indicator for the corresponding market that enables a comparison between the current and a past price level. An index can depict the world market, the market on a single continent or in a single country, or even a specific sector or theme.

If you combine the concept of a stock index with ESG criteria, you get an ESG index. But in what way does an ESG index differ from a conventional index? The difference lies mainly in the selection of companies contained in the index because in addition to common criteria such as market capitalization and perhaps a company’s stock trading liquidity, ESG criteria also get factored in. This means that insufficiently sustainable companies do not get included in an ESG index or are weighted differently in it. An ESG index thus consists of companies that meet certain sustainability criteria and excludes or underweights less sustainable companies.

Let’s take a closer look now at how an ESG index originates, taking the SPI ESG Index based on the Swiss Performance Index (SPI) as an example. The SPI includes almost every Swiss company listed on the Swiss stock exchange. The SPI standard index contains 217 companies (status as of 2023). The weights of the individual companies in the index are calculated on the basis of market capitalization (number of shares outstanding x free-float factor x share price). The ESG index additionally factors in ESG criteria using data that SIX obtains from Inrate, a Swiss rating agency that conducts company sustainability assessments. Evaluating sustainability performance is a challenging undertaking because not all corporate data are available in detail. The data are used in four steps to construct the ESG index.

1.       In the first step, all companies that derive revenue from one or more of the business areas listed below are excluded. The exclusion threshold is usually set at 5% of total revenue:

• Adult entertainment
• Alcohol
• Armaments
• Gambling
• Genetic engineering
• Nuclear energy
• Coal
• Tobacco
• Oil sands

2.       Next, companies are examined for their compliance with the UN Global Compact principles, a voluntary set of standards for businesses that was developed by the United Nations Organization to make globalization more socially equitable and ecological. The UN Global Compact contains ten principles that companies are expected to fulfill. The principles cover issues concerning human rights, work conditions, the environment, and corruption. Companies that violate these principles or are unwilling to pursue sustainability as a business objective are excluded from the ESG index.

3.       The Swiss Association for Responsible Investments maintains an exclusion list, or blacklist, of companies it advises against including in sustainable financial products. If a company appears on the list, it is not included in the ESG index. Not a single publicly traded Swiss company is on the list at present.

4.       The final but not the least important step in the process is a company’s ESG rating. Inrate issues ESG impact ratings for companies that measure how sustainable an enterprise is. Each company is assigned a score on a 12-level scale from D- to A+. A company must have an ESG impact rating of C+ or higher to be included in an ESG index from SIX. A score of C+ means that a company is not yet sustainable, but is making distinct efforts to improve its practices. In January 2023, 44 companies are below C+ (see illustration).

After these four steps in our example, around 160 companies are left in the SPI ESG index. This means that 51 companies in the SPI currently do not meet the sustainability criteria required for inclusion in an ESG index from SIX (see illustration).

To calculate an ESG rating, Inrate analyzes the ecological and social impacts that a company’s products and business practices have on the environment and society. A company’s willingness and ability to address ESG-related problems also factor into the rating. Inrate bases the rating on data gleaned from sources such as company, sustainability, and media reports, for example. Its methodology also assesses the impacts of a company’s production practices and products on the environment and society across entire product life cycles (i.e. including upstream processes, during the period when the product is in use, and after it has been disposed of). The data get updated periodically, and the ESG rating methodology is regularly reviewed and modified in line with general or regulatory developments in the market.

SIX provides an array of different ESG indices. SIX, for example, produces broad-market ESG indices such as the SPI ESG Index, which contains all of the constituent companies in the standard SPI that meet the requisite sustainability criteria. There are also weighted indices such as the SPI ESG Weighted Index, which weights the individual constituent companies in a different way, not just on the basis of pure market capitalization, but also by factoring in ESG criteria. Put simply, companies that are more sustainable are given a greater weight in the index.

SIX also supplies ESG subindices (large-, mid-, and small-cap) and customized ESG indices derived from the SPI and the SPI ESG index. The SPI Gender Equality Index only includes companies where women hold between 20% and 80% of board of directors seats and between 15% and 85% of executive management positions. And last but not least, besides the stock indices, there is also a multitude of ESG bond indices such as the SBI ESG Index and the many indices derived from it.

The use cases for ESG indices are generally the same as the use cases for conventional indices. ESG indices serve as an indicator and as an underlying asset. Financial institutions can create investment products such as exchange-traded funds (ETFs) or index funds that replicate an index, and investors in turn can then invest in those products. SIX thus supplies index data to banks and other financial institutions to enable them to construct index-based financial instruments. With its ESG indices for the equity and bond markets, SIX provides a consistent family of ESG indices as a reference and a market standard. Together with the raw ESG data and the regulatory data that SIX provides, the ESG indices form a comprehensive product offering for users of ESG information.

As the universe of sustainable investing strategies is growing, so is the demand for shares and bonds of sustainable companies. And this gives less sustainable enterprises an incentive to improve their sustainability practices in order to gain inclusion in ESG indices and in the investment products based on them.