When compliance, legal and investment professionals talk about ESG (Environmental, Social Governance) standards and integrating them into their investment analysis, they tend to use a lot of different terms. These include sustainable investing, ESG investing, socially responsible investing (SRI), green investing, ethical investing, and impact investing. These terms make it difficult for those less informed about ESG, and even some who are well informed about ESG, to understand whether or not these standards have been integrated into their investment analyses and processes.
However it’s not just financial types who need to understand the integration of ESG standards. Professionals up and down the ranks of senior management are accountable to employees who rely on financial analysis that incorporates ESG standards in their pension investments. And if there isn’t a pension, there are still a variety of constituents — students, investors, customers, investment committees, among others — who may want assurances that the enterprise incorporates factors other than purely financial ones when measuring investment potential.
Understanding what ESG integration is can be eased by pointing out what it is not. ESG integration does not mean that:
- Investment in certain sectors, countries, and companies is prohibited. Typically, exclusionary screening is implemented before any investment analysis takes place. This is contrary to ESG integration, where financial information and ESG information are embedded in the security selection and portfolio construction process and all companies, sectors, and/or countries in the investment universe can be bought and sold.
- Portfolio returns are sacrificed to perform ESG integration techniques. A key component of ESG integration is lowering risk and/or enhancing returns. Practitioners apply ESG integration techniques to uncover hidden risks that might remain undiscovered without the analysis of ESG information and ESG trends. Further, like all investment professionals ESG practitioners also look for investment opportunities to enhance returns. For example, some practitioners analyze automotive companies to see how they are reacting to trends in car electrification and factor this assessment into their revenue forecasts.
- Immaterial ESG factors affect investment decisions and traditional financial factors are ignored. Once ESG factors take their position alongside traditional financial metrics, they are subject to the same materiality assessment. For instance, material ESG issues related to a sector may not be valid for all companies in the sector because of their business lines, products or unique management of ESG issues. Further, the investment time frame matters as ESG factors are more likely to impact long term investors — positively and negatively — than short term investors. As a result, an environmental issue may be immaterial in the short term, but massively influential in the long term. For example, climate change may not impact an insurer this quarter but over the coming years is expected to be a major concern for some insurance companies as the impacts of climate change are expected to become more pronounced.
- Wholesale changes in an organization’s investment process are necessary. ESG integration is a useful complement to practitioners’ current investment process and practices, not a wholesale transformation of it. The main addition to practitioners’ process is the sourcing and analyzing of ESG information, which is necessary to understand the top ESG issues affecting a company, sector, or country.
The incorporation of ESG standards into an investment process means the explicit and systematic inclusion of ESG factors into the analysis and the ultimate investment decisions. It is a holistic approach to investment analysis, where material factors—ESG factors and traditional financial factors—are identified and assessed to form an investment opinion and decision.
Within this framework, ESG integration typically has three components.
- The first is research. Here, practitioners gather financial and ESG information from multiple sources including but not limited to company reports and third-party investment research.
- Second, ESG research needs to be put into context for materiality. This makes sense. After all, traditional analytical metrics such as growth, competition, technological risk are put through a materiality screen and immaterial factors are dismissed. In short, materiality debunks the myth that ESG integration requires a prohibition against investing in certain sectors.
- Third, research must be vetted. To be effective, it needs to be put into action in terms of engagement with the issuers on ESG and traditional metrics and evaluated against corporate activities and voting.
Finally, with research in hand and vetted against management commentary and voting history, ESG and traditional financial factors are used to adjust forecasts, variables in financial models, valuation multiples, key financial ratios, internal credit assessments, and/or portfolio weightings.
Notably, within this framework, ESG is given equal weighting with traditional financial inputs to reach buy/sell, hold, increase/decrease and invest/not invest decisions. Further, ESG integration is seamlessly achieved, neither supplanting or diminishing traditional financial research.
These principals and precepts were not developed in isolation. Rather, they were derived from a collaboration between Principles For Responsible Investment (PRI) an organization that promotes responsible investment and CFA Institute. In our work together to provide a foundation for best practices with respect to ESG integration, we surveyed 1,100 financial professionals around the world, predominantly CFA members, ran 23 workshops in 17 markets and published more than 30 case studies among other activities.
As a result, the ideas in this article are not the work of enlightened analysts, but rather aggregate the thinking of charter holders and other professionals from around the world. In this respect, they offer global insights into the best practices of ESG integration. Moreover, the complete work provides a framework for practitioners to use when comparing their ESG integration.