Navigating the ESG labyrinth

A fiduciary duty to make money for stakeholders now means that ignoring environment, social, and governance (ESG) factors is more likely to cost you performance than enhance it. Integrating ESG will also lead to better-informed investment decisions and reduce the overall risk of a portfolio.

Trends such as climate change, resource scarcity and greater regulation affect companies more than ever before, but they also provide opportunities for new markets in areas such as renewable energy or cybersecurity. So, it pays to be well informed about how sustainable investing works, and what it can do for clients.

There are many ways to approach the incorporation of sustainability into investment portfolios. Increasingly, this means more than just offering sustainable investment funds.

Integrated sustainability also means using a position as a shareholder (or bondholder) to effect change at companies through active ownership, typically through voting and engagement. It also includes impact investing, where an investment is aimed at achieving a social purpose such as meeting one of the UN’s Sustainable Development Goals (SDGs) as well as earning a financial return. 

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Of course, it still means adopting key exclusions, such as refusing to buy shares in controversial weapons makers or tobacco producers. 

All of these approaches should be considered as building blocks to be configured appropriately to suit each asset class, strategy or client. 

As the world moves on, sustainable investing now means combining both healthy returns and a positive effect on the world around us; to create wealth and wellbeing that meets the needs of the present generation without compromising those of generations to come. 

THREE ESG APPROACHES

There is no one-size-fits-all approach to sustainable investing. When considering different asset classes, different methods are better suited than others. But there are three approaches the asset management industry broadly uses for sustainable investing and for addressing ESG issues in portfolios. 

The most common is the use of exclusions – avoiding investments in companies that produce controversial products such as weapons or thermal coal, or are involved in practices such as the production of unsustainable palm oil. For some investors, this is their only form of practicing sustainable investing, which means they may miss out on the benefits of using the other styles. 

At Robeco, we prefer the less common but more comprehensive approach of systematically integrating ESG factors into portfolio construction. This means analysing financially material information to take better-informed investment decisions and thereby improve the risk/return profile of a portfolio. This method ensures the thorough absorption of sustainability factors in portfolio construction from both the top-down and bottom-up perspectives. 

The third approach used by the industry is impact investing, where an investor wants to make a socioeconomic impact as well as enjoy the financial returns. This is often done by targeting themes or initiatives such as the UN SDGs. 

While exclusions are the most widely-used means of negative screening, impact investing is a form of positive screening, where the focus is on deciding what to put in instead of what to leave out.

The three common approaches of sustainable investing – exclusion, integration and impact – come together when ESG criteria are thoughtfully built into the investment process and tailored according to the specificities of each asset class and portfolio objective. 

Most of the underlying building blocks can be used as an input or guide across all asset classes. In general, ESG analysis in equities seeks to identify an upside that is not necessarily reflected in the share price, while analysis in bonds seeks to expose any downside that may not show up in its credit rating.

However the big advantage of ESG integration is that it works across all asset classes – and it has been proven to work just as well in fixed income markets as in equities. It can also be applied to commodity or real estate portfolios or private equity.

Equities and ESG factors

Using equities as an example, it is clear that integrating ESG factors into the investment process leads to better-informed investment decisions. 

ESG integration in fundamental equity investments can be seen as a three-step process. The first step is to identify and focus on the most financially material ESG issues affecting the company. The second is to analyse the impact of these material factors on the company’s business model. Thirdly, the challenge is to incorporate these factors into the valuation analysis and/or the fundamental view of the company in order to decide whether to buy the stock. 

Identify material ESG factors

Focusing on the most material factors is key, and this will vary by company or industry. Analysts should plot the highest likelihood of an issue making an impact against the degree of this potential impact. A huge number of data sources are used in order to gain the information needed to assess the likely impact of all these factors.

With IT services, for example, innovation management is the most material issue, followed by human capital management and corporate governance. Environmental management, however, is a relatively low risk, since IT companies generally have a low carbon footprint and generate little pollution. 

Other industries are of course different, and separate analysis is required for each one: for the pharmaceutical industry, for instance, the ESG issue of paramount importance is product quality and safety. 

Impact of material factors on business model 

In the second step, analysts look at how the business model of a company is exposed to the material ESG factors identified in step one. 

Here, in-depth analysis should be conducted, including delving deeply into a company’s value drivers, such as sustainability of growth in an industry; a company’s competitive advantage; and market share. Analysts can then benchmark a company’s financial and ESG performance against its peers and industry-best practices, and also assess the impact this may have on valuations. 

ESG CRITERIA: QUANTIFY IMPACT ON VALUE DRIVERS 

In the third step, the impact of the ESG analysis is integrated into the valuation assessment. If the ESG impact is substantial, for example, traditional value drivers such as sales growth and margins or the weighted average cost of capital are adjusted. The ESG analysis may also result in altering a company’s competitive advantage period: the period over which it can generate excess economic returns. 

The resulting impact of material ESG factors can be positive or negative, reflecting risks or opportunities that ensue from a company’s ESG analysis. 

Of course, ESG performance isn’t the only reason to buy or sell a stock. However, if ESG risks and opportunities are significant, the ESG analysis will impact a stock’s fair value and the decision whether to buy a stock – or not to buy it. 

ESG CRITERIA: SDG RESEARCH

More recently, there has been a sharp increase in support for and interest in the UN SDGs in the sustainable investing landscape. 

Many sustainability frameworks focus mainly on how companies operate, but our SDG rating framework looks at both how they behave and what they produce. The SDGs offer a comprehensive framework that is broad enough to cover the full range of causes (e.g. humanitarian, ecological and economic) yet specific enough to guide companies on the exact criteria needed to achieve each goal.

ESG CRITERIA: VOTING & ENGAGEMENT

Asset managers may actively engage with a portfolio holding on ESG matters for different reasons. An example is if the company in question were to breach the UN Global Compact. In such a serious case, an ‘enhanced engagement process’ would be initiated, and Robeco’s approach here is that part of the portfolio’s exposure to the stock would be reduced by half.

In extreme cases when enhanced engagement does not prove to be successful, the company is added to the exclusion list. Exclusions are considered as a last resort, as the preferred approach is engagement.

THE BEST APPROACH

There is no one-size-fits-all approach to sustainable investing. However, over the course of time, consensus has grown on what approach fits various types of investors best. 

Investors at one end of the spectrum only consider financial criteria, while those at the other only consider social criteria, including philanthropy. Institutional investors generally have a focus on strategies in which sustainability is considered to mitigate risks, enhance value or create impact, alongside achieving competitive returns. 

Masja Zandbergen is head of sustainability integration at Robeco.