Exclusion and Norms-Based Screening: Controversial Weapons, Thermal-Coal Thresholds and UN Global Compact Violations

What you will learn

• The difference between activity-based, revenue-threshold and norms-based screening.
• Which weapons count as "controversial" and why they usually have a 0% threshold.
• How thermal-coal thresholds of 1%, 5% and 30% lead to very different portfolios.
• How a UN Global Compact screen works and what "watch list" means.

Explanation

Screening removes companies from an investable universe before any rating or weighting. It is the most transparent sustainable-investing tool because every rule can be written down and tested. Three families exist.

1. Activity-based screens with a 0% threshold

Some activities are excluded at any level of involvement. The clearest case is controversial weapons: weapons banned or restricted by international treaties, usually anti-personnel mines (Ottawa Treaty, 1997), cluster munitions (Oslo Convention, 2008), biological weapons (1972 convention) and chemical weapons (1993 convention). Many lists add nuclear weapons, depleted uranium and white phosphorus, so lists differ. Here the screen asks only "is the company involved in production or key components?", not "how much revenue?". The EU climate benchmarks (lesson 4) and the ESMA naming rules (lesson 5) both require this exclusion.

2. Revenue-threshold screens

For activities that are legal but unwanted, the screen uses a revenue share: excluded if revenue from the activity is at or above X% of total revenue. The choice of X is the whole game:

Thermal coal is coal burnt for power and heat; metallurgical coal for steel is usually treated separately. Check the denominator too: "revenue from coal power" differs from "share of electricity generated from coal", and providers estimate when companies do not report.

3. Norms-based screens

Here the question is behaviour, not product. The reference is usually the UN Global Compact (UNGC), ten principles covering human rights, labour standards, the environment and anti-corruption, often combined with the OECD Guidelines for Multinational Enterprises. A data provider assesses controversies and classifies a company as compliant, on a watch list (serious allegation, outcome unclear) or non-compliant (confirmed severe violation with no credible remedy). Only non-compliance normally triggers exclusion; the watch list is a warning. Because this is a judgement, providers disagree here even more than on ratings, and a company can be "non-compliant" with one provider and "watch list" with another.

How screens change an index

Excluded weight does not disappear: the remaining companies are re-weighted, usually proportionally, so every survivor gets a slightly larger weight. The more weight is removed, the more the screened index deviates from its parent, which shows up later as tracking error (lesson 11).

Worked example

Hypothetical example: a fictional parent index contains 100 companies. Five of them have thermal-coal revenue. All figures are invented.

Step 1 – apply a 1% threshold (coal revenue ≥ 1% excluded): U1, M2, I1 and E1 are out; M1 stays at 0.8%. Removed weight = 2.0 + 1.0 + 0.5 + 0.8 = 4.3%.

Step 2 – apply a 5% threshold: U1, I1, E1 are out. Removed weight = 2.0 + 0.5 + 0.8 = 3.3%.

Step 3 – apply a 30% threshold: only E1 is out. Removed weight = 0.8%.

Step 4 – re-weighting. A surviving company with a 3.0% parent weight becomes 3.0 ÷ (100 − 4.3) = 3.0 ÷ 95.7 = 3.13% under the 1% rule, 3.0 ÷ 96.7 = 3.10% under the 5% rule and 3.0 ÷ 99.2 = 3.02% under the 30% rule.

Step 5 – norms screen. Suppose a sixth company, a fictional apparel maker with 1.2% weight, is classified as UNGC non-compliant because of confirmed forced-labour findings. It is excluded regardless of revenue; under the 1% rule the total removed weight rises to 4.3 + 1.2 = 5.5%.

Assumptions: proportional re-weighting, no sector caps, no transaction costs from rebalancing, and no change in company revenue between reviews.

Common mistake

Practice activity

On paper: a fictional index has three flagged companies: P (weight 1.6%, 7% coal revenue), Q (weight 0.9%, 0.5% coal revenue) and R (weight 2.4%, UNGC watch list, 0% coal). Apply a screen that excludes coal revenue ≥ 5% and UNGC non-compliance. (a) Which companies are removed? (b) What total weight is removed? (c) What is the new weight of a surviving company with 2.0% parent weight?

Key takeaways

• Controversial weapons are usually excluded at 0%; legal but unwanted activities use revenue thresholds.
• For thermal coal, 1%, 5% and 30% thresholds produce very different portfolios; check the threshold and the denominator.
• Norms-based screens judge behaviour against the UN Global Compact; only confirmed non-compliance normally excludes.
• Excluded weight is redistributed to survivors, which creates deviation from the parent index.

Next step

The next lesson moves from removing companies to selecting and tilting them: ESG Leaders, SRI, Paris-Aligned and Climate Transition Benchmarks with their numerical rules.