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2 ESG: Integration
[Introduction]
In this concept, we will examine how we apply ESG analysis and valuation into the broader investment
process, i.e. how we integrate ESG. Each company will adopt their own processes and procedures, but for
illustrative purposes let's use the following definition.
ESG integration is the explicit and systematic inclusion of ESG factors into investment decisions.
In other words, asset owners and managers should walk the walk and embed ESG so that it systematically
impacts the investment portfolio, rather than talk the talk and "greenwash" (present the form but not the
substance that they are integrating ESG).
Some companies have a dedicated ESG team supporting the portfolio management process, others such as
Robecco embed ESG deep within the asset management process.
ESG integration requires the application of ESG research analysis and valuation into all of the following
stages of the investment management process:
[Aims of Integration]
Reasons for ESG integration
The below video details more information on the reasons why asset managers integrate ESG into
investment.
The reasons why asset managers integrate ESG into the investment process fall into three main categories:
- They have to
Fiduciary duty or regulatory requirements: Regulations and legal requirements already exist requiring
asset managers and owners to consider or disclose ESG factors. These could be fiduciary responsibilities
of trustees to a pension fund who must consider the very long run exposure of scheme assets to
environmental risks.
- They need to
Lowering reputational risk: Asset owners, particularly those with a wide range of beneficiaries, are open
to intense media scrutiny and will suffer negative reputational risks if they are exposed to ESG failures
or scandals.
Client and beneficiary demands: Clients demand ESG services and asset managers need to deliver ESG
solutions to manage the success of their own business. Some charities have for many years demanded
that their asset managers use negative screens to exclude "sin" stocks from the portfolio such as
tobacco, weapons and gambling.
- They want to
Integrating ESG into the investment process can lower investment risk, increase return and may lead to
opportunities to create "alpha" (risk adjusted outperformance) possibly through improved engagement
and stewardship. There is a growing body of research with consensus that companies with high ESG
scores have a lower cost of capitals than peers. In addition, incorporating ESG factors within the
research and analysis process provides a new lens to assess risk and returns.
Relevant research supporting these reasons for integrating ESG includes the following:
"Sustainable Investing" – Deutsche Bank: Firms with high ESG scores have lower costs of capital, higher
financial performance and market returns
"ESG and Financial Performance" – Friede, Busch and Bassen: Meta study of 2200 studies suggesting >
90% of companies with high ESG scores do not generate negative relative performance
"Link between ESG, Alpha and the Cost of Capital" – Kolbel and Busch: ESG Momentum policy provides
opportunity for outperformance and ESG research limits exposure to stranded assets
[Approaches to Integration]
Stage 1 - Set investment policy incorporating ESG objectives and impacts on the "real world" as well as
return and risk objectives of the fund:
Effective incorporation of ESG factors into objectives is of critical importance as this will drive behavior of
the asset manager. Objectives need to be specific and capable of being executed. The PRI refer to "real
world impact" meaning the requirements to generate results beyond simple risk and return dimensions, to
include for example, reduction of greenhouse gas (GHG) emissions, promotion of diversity and best
principles of governance.
=Define risk/return objectives and consider a third dimension objective to maximize "real world impact".
Stage 2 - Determine strategic asset allocation (SAA) approach considering impact of ESG factors:
We note that ESG factors traditionally have not had a large impact on strategic asset allocation. No single
asset class dominates another on the basis of ESG. Equity as an asset class does not dominate fixed income
as having higher E, S or G characteristics. It could be argued that an investor can use equity to exercise
more active engagement through voting rights associated with equity and not fixed income, but this is the
case regardless of ESG motivation. However, whilst research suggests ESG has limited impact on the SAA
decision, it does facilitate scenario and risk assessment to ensure the portfolio manager considers the
impact of significant changes to ESG factors, such as climate change on broader asset performance.
= Consider impact of ESG risks and opportunities on expected risk, return and correlations assumptions,
undertake scenario analysis.
ESG considerations should have a significant impact on the selecting of securities, excluding poor ESG
performers and overweighting those with good ESG scores.
[Managing Risk and Return in an ESG Integrated Portfolio]
Most forms of ESG integration will impact the final portfolio by excluding or limiting exposure to securities
with low ESG scores. Although this won't necessarily result in lower returns there is a risk it may, so
investors need to decide how much return they are willing to sacrifice to obtain their ESG objectives.
If a client had a required Sharpe ratio of 1, given the investment opportunity set of A and B, this would lead
to the investor choosing the optimum portfolio X, which is a combination of A (good ESG security) and B
(bad ESG security).
The allocation to B may be too high for an investor with ESG objectives. The asset manager can discuss this
with the investor and determine how much of a return "penalty" they are willing to take to reduce
exposure to B. This penalty can be expressed by reducing the required return premium for each unit of risk
(the penalty function), which in turn reduces the required Sharpe ratio. This would require a specific
agreement to enable the manager to execute the client’s ESG objectives. For example: Accepting a 0.1
percent change in the portfolio's Sharpe ratio resulting from each 1 percent change in the asset weighting.
This creates a lower risk return trade off leading to the new optimum portfolio X, which has a lower
allocation to B and a higher allocation to A, as shown.
In practice, the discussion regarding the penalty function may not result in the re-optimization process
described here, which is based on all the assumptions of modern portfolio theory being met, but it is a
discussion that needs to take place to ensure client expectations are set and met.
Instead when analyzing a carbon-intense company, CRAs focus on the other material impacts – including
financial, regulatory and legal factors, which are expected to have an impact of the ability of the company
to generate cash flow and meet scheduled payments on the issued bond.
Surveys from investors suggest the G factor remains more important to credit investors than E and S and
governance factors can be very important in protecting bond investors from negative credit events.
Infrastructure projects range from development of new road systems to solar energy generation systems.
ESG analysis therefore needs to be undertaken on a case by case basis, considering upstream and
downstream effects of investment. Such direct investment projects lend themselves to engagement policies
enabling investors to drive activities in a manner compliant with their ESG objectives.
[Challenges of ESG Integration]
Impact of ESG analysis and valuation challenges on ESG portfolios
Having previously examined the impact poor, incomplete and scarce data has on ESG analysis and
valuation, we will now look at how these challenges impact the outcome of an ESG integrated investment
process. The major causes for concern include the following:
1. Portfolios may include poor companies
Also known as "bad actors", these are companies that "green wash" their corporate disclosures
to increase their ESG rating, but which, in reality, follow poor ESG practices.
2. Dubious Assessment Criteria
Flawed or subjective materiality assessments lead to important ESG factors being ignored.
3. Potential lack of emphasis of long-term improvements:
ESG factors impact performance over time, whereas asset managers must report performance for
short-term cycles, often quarterly. This commercial pressure may lead them to ignore investment
in companies which can deliver significant ESG benefits and returns.
4. Trading signals & inefficiencies:
The essence of ESG integration is how it affects securities positioning and sizing (what and how
much to hold). Many trading decisions are made within tight time parameters and require signals
to be simple and transparent to be understood and enacted. In practice, ESG signals are often
subjective and slow to be reflected in price and volatility movements.
[Recap]
In conclusion, asset managers look to integrate ESG into the investment process responding to fiduciary
and regulatory requirements, investor demands for ESG products and because there is evidence that
consideration of ESG factors can improve the risk/return characteristics of investment decisions.
ESG can be integrated at any stage of the investment process, but increasingly asset managers are
responding to client demands by embedding ESG in all aspects of the portfolio creation and management
process.
Although ESG is often used in the management of equity portfolios, the assessment of ESG factors are
relevant to all asset classes. However, in practice it is fixed income decisions that are primarily influenced
by governance factors. The main challenge to the successful integration of ESG is the availability and quality
of information. Poor, unreliable and scarcity of data may result in investments decisions being made that do
not deliver on the objectives of investors without qualitative intervention by experienced asset managers.