Understanding environmental, social and governance (ESG) integration in investing.
You may have heard of the term ESG integration, but what does it mean in practice? Simply put, environmental, social and governance criteria are a set of factors that investors can use to analyze potential investments.
Back in the early 2000s, there was growing recognition that factors associated with ESG issues – traditionally not part of financial analysis – affected the financial performance of a business or the economy. Today, research has clearly established the link between long-term sustainable performance and good financial results. At the same time investors are increasingly aware of issues such as energy and water use, climate change, diversity and human rights. Investing with ESG in mind has come of age.
How it works
“Globally, sustainable investing stood at over $30 trillion at the start of 2018, a 34 per cent increase from two years prior [and] the Principles for Responsible Investment (PRI) now includes over 2,300 investment firms globally as signatories,” says Margaret Childe, Director of ESG Research and Integration at Manulife Investment Management, citing the Global Sustainable Investment Review, 2018.
Many investment management firms offer ESG integration. Margaret Childe defines this as the explicit and systematic inclusion of ESG issues in investment analysis and decisions. Teams that have adopted ESG integration look at:
- Environmental factors – how a company’s operations affect the natural environment, and how the natural environment affects the company
- Social factors – the relationship between a company and its employees, suppliers and communities
- Governance factors – the structures or systems a company has put in place to ensure effective direction and control
Identifying areas of concern can help these teams avoid investing in companies with ESG vulnerabilities. Just as important, identifying ESG strengths can help investment teams select companies with good potential for long-term growth.
“While it’s true that firms incur operational and disclosure-related costs as they engage in good corporate behaviour and enhanced disclosure, they also stand to benefit from efficiency gains, greater trust from stakeholders, reducing risk and other long-term benefits,” says Childe. “Companies are acknowledging these benefits and taking action. Many companies globally have increased their focus on actively managing and reporting on ESG risks in order to remain competitive in the global market for products and services.”
Not all approaches are the same
ESG integration is distinct from two other approaches to ESG-conscious investing. Screened strategies rule out groups of companies (e.g., tobacco companies or weapons manufacturers), making them easy to apply; however, excluding too many companies from consideration can lead to greater volatility. Sustainable strategies focus on companies that are positioned to capitalize on the long-term macroeconomic trend of sustainability; again, this can lead to a concentrated portfolio and more volatility. In contrast, integrated strategies look at every potential investment through the lens of ESG, supported by the assumption that more informed investment decisions lead to better outcomes.
The ESG advantage
The ESG lens may be applied at the due diligence stage before an investment firm makes an investment, at the risk monitoring stage when the team is keeping tabs on portfolio holdings, and when the team engages in “active ownership,” working directly with companies to improve their ESG profiles and deciding how to direct proxy votes. The key, with ESG integration, is that it’s part of an overall philosophy that is committed to reducing risk and improving returns over the long term for investors. An added benefit is that it requires companies to be more accountable for their ESG impacts, which can lead to a more ESG-conscious world.
HOW CAN ESG FACTORS AFFECT A COMPANY?
ESG factors can have a material impact on a company’s profitability. As Margaret Childe points out, in 2011, Intel revised its fourth-quarter earnings forecast down by US $1 billion because hard drives were in short supply due to floods in Thailand. Three years later, in 2014, Coca-Cola was forced to shut a bottling plant in northern India because of water scarcity, raising questions about the company’s expansion potential in the world’s second most populous nation.
On the other hand, forward-thinking ESG practices can generate growth opportunities. Over at Coca-Cola’s competitor PepsiCo, former CEO Indra Nooyi responded to concerns about the public health impact of sugary treats and started directing research and development dollars towards healthier alternatives.Looking more broadly, MSCI researchers have found that companies rated higher for ESG factors have tended to demonstrate higher profitability and lower risk; furthermore, they have proven to be more competitive and often generated higher dividend payments compared to companies rated lower for ESG factors.
Are your investments benefiting from ESG integration? Speak with your advisor to find out.
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