What is ESG Integration?
The increasing adoption of ESG integration strategies is a major trend that is transforming finance. Yet despite the boom in ESG integration and growing commitments from mainstream asset managers and asset owners, ESG integration is still often misunderstood in the market. In this article, we provide a short primer on the basics of ESG integration.
First, what is ESG?
In the most basic sense, ESG stands for Environmental, Social, and Governance. These are 3 key factors that can be used to evaluate the risk and return profile of an investment. Some illustrative examples of ESG issues are:
Environmental: Carbon emissions, pollution, biodiversity, water scarcity, deforestation
Social: Diversity, employee engagement, customer satisfaction, human rights, data protection, employee health and safety
Governance: Board quality and composition, bribery and corruption, executive compensation
ESG issues can often be quantified in metrics such as the scope 1-3 carbon emissions of a company, water withdrawals, diversity percentages, customer retention rates, and number of data privacy breaches. In fact, many investors are seeing ESG as a way of getting new alternative datasets that complement the overall investment process by expanding the amount of information that can be used to assess risk and return.
The universe of potential ESG issues and corresponding metrics is vast and therefore a key element of ESG investing is selecting the most relevant information to consider. The exact ESG issues that matter will vary based on characteristics such as the investment style, sector and industry, geography, and market trends.
“CFA Institute encourages all investment professionals to consider ESG factors, where relevant, as an important part of the analytical and investment decision-making process, regardless of investment style, asset class, or investment approach.”
What is ESG integration?
The Principles for Responsible Investment (PRI) defines ESG integration as “the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions”. Key here is the word systematic, as true ESG integration systematically identifies relevant and material ESG issues and embeds them in the investment process, for instance through the use of ESG datasets and technology.
“ESG integration is the practice of incorporating material ESG information into investment decisions with the objective of improving the long-term financial outcomes of our clients’ portfolios, consistent with our clients’ objectives”
The primary reason why investors consider ESG issues is because they are financially material and therefore can be expected to impact investment performance. Another key driver for ESG integration has been demand from clients (e.g. pension funds and family offices) who are seeking to invest sustainably while obtaining financial returns.
It’s important to note that ESG factors can be incorporated in the investment process using a range of strategies. ESG integration is the leading strategy among mainstream investors, but it’s not the only approach. Other key ESG incorporation strategies (which can have different implications for the risk, return, and impact generated) are:
Exclusionary screening (negative screening): Certain companies are excluded based on their industry (e.g. oil & gas) or products/services (e.g. weapons, alcohol, tobacco) which are deemed undesirable or are linked to negative impacts. Screens can be absolute (e.g. no investment in weaponry). Screens can also be applied using a threshold – for instance permitting investment in companies that derive less than 10% of their revenues from alcohol manufacturing.
Positive screening: Portfolios can also be constructed using positive screening by selecting or overweighting investments in companies or sectors known to be top ESG performers or have relatively more positive impacts.
Impact investing: Investments are made with the intention of creating measurably positive impacts for society and the environment alongside a financial return (ranging from market-rate returns to below-market rate returns). Typically, impact investors provide capital to solve social and environmental problems such as addressing climate change.
Active Ownership: Investment is accompanied by investor engagement and voting to exert influence on portfolio companies. Typically, active ownership seeks to drive progress and catalyse changes in corporate practices, policies, and business strategy in response to material ESG risks and opportunities.
ESG integration is currently the most popular approach, followed by exclusionary screens, according to BlackRock’s 2020 client survey.