Understanding ESG Part 2: ESG integration and responsible solutions
Asset managers and their clients are increasingly incorporating environmental, social and governance considerations – collectively known as ESG – into their investment decisions. This reflects the spectacular rise of responsible investing – an investment ethos that can deliver benefits beyond the bottom line and recognises that modern-day investment should be a matter of long-term ownership and sound stewardship.
In this article we focus on what is known as ESG integration. This term is used to describe how the various aspects of E, S and G are incorporated into investment processes. We survey the spectrum of responsible investing, outline some of the different strategies available and break down the journey from data to decisions and beyond. Crucially, we explore why Invesco believes that ESG – like any form of successful investing – should support the search for holistic solutions that can result in a superior investment experience.
What is ESG integration?
The Principles for Responsible Investment (PRI) coined the term “ESG integration” in 2006, defining it as “the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions”. It is important to take a closer look at precisely what this means – and, indeed, what it does not mean.
Ideally, it should mean that ESG factors – alongside other material considerations – are taken into account in arriving at suitably informed investment choices. It should not necessarily mean that traditional financial factors are overlooked, that certain investments are automatically ruled out or that returns are sacrificed in favour of sustainability.
As we remarked in the first article in this series, one goal of responsible investing and ESG is to combine a desire for financial performance with a determination to serve the greater good. We can think of these twin objectives as a barbell. Some ESG investments might be geared more towards returns, while others might lean more towards “doing the right thing”.
Different balances can be struck through different types of ESG investment. In the next section, with reference to a spectrum of responsible investing, we will examine in more detail how this is done. At this stage the key takeaway is simply that ESG integration underpins every strategy, irrespective of whether the main aim is to achieve attractive performance or to deliver broader benefits.
As we also noted in our first article, ESG integration usually seeks to identify businesses and other entities that are already proactive in their attitudes to environmental, social and governance issues or which are able and/or prepared to make progress in this regard. The process normally begins with data, although this is not always the be-all and end-all. As we will also see in due course, how the journey unfolds is again likely to depend on the kind of ESG investment undertaken.
PRI definition of ESG integration
“ESG integration underpins every strategy, irrespective of whether the main aim is to achieve attractive performance or to deliver broader benefits.”
Types of ESG investment
We observed in our first article that some manner of responsible investing has existed for centuries, with faith-based investors in particular avoiding sectors at odds with their beliefs or values. The present-day descendant of this basic approach, in which exclusion is the principal determinant of how assets are selected, uses a process known as negative screening.
This represents the least sophisticated type of ESG integration. It is designed only to remove from the investment universe any prospects that might not be aligned with an investor’s personal preferences. Some screens may exclude “sin” stocks – for example, those in sectors such as tobacco, alcohol, munitions, gambling or adult entertainment – while others might reject businesses whose levels of CO2 emissions are not conducive to the fight against climate change.
While negative screening in effect looks to weed out “bad” companies, it is also possible to concentrate on “good” businesses. ESG integration of this sort might be described as sustainability-focused, as it searches for positives rather than negatives – either in individual organisations with superior ESG performance or across themes such as clean energy and carbon reduction. The intention in this instance is not merely to discover reasons to exclude: rather, it is to discover reasons to include as well.
Whereas sustainability-focused solutions inhabit the middle of our responsible investing spectrum, as shown below, what is known as impact investing occupies the extreme of the continuum in terms of “doing the right thing”. The primary goal of impact investing is to generate a measurable benefit, usually in relation to environmental or social concerns, with financial performance clearly of secondary significance. This sort of ESG investment is in its comparative infancy, but the scale of its ambition should not be doubted.
The variety of ESG investments discussed here highlights a vital point, which is that there is no “one size fits all” strategy in this ever-developing sphere. Different ESG investors have different ESG needs, which is why we strive to provide a range of solutions – as explained in more detail in the next section.
“The variety of ESG investments highlights a vital point, which is that there is no ‘one size fits all’ strategy in this ever-developing sphere.”
The search for solutions
As well as sparking a range of ESG investment types, the rise of responsible investing has seen increasing demand for low-cost ESG solutions – especially as the phenomenon has moved from the margins to the mainstream. As a result, many of the approaches outlined in the previous section can now be accessed via both passive and active strategies1.
This means that any investor who wishes to contribute to positive, lasting change has the capacity to do so. In other words, the ability to make a difference is not confined to institutions or professional investors. There are ESG solutions to suit anyone.
This brings us back to a point touched on earlier: how the ESG integration journey unfolds. As we know, it almost invariably starts with the analysis of a wealth of data pertaining to an array of environmental, social and governance considerations. Data is the undisputed lifeblood of ESG integration, and it is core to the processes by which assets are selected for passively managed strategies such as ETFs – which can offer a straightforward, cost-efficient and effective route into responsible investing.
Some investors, though, prefer a more “involved” journey. Actively managed strategies put greater emphasis on direct engagement, adding a layer of qualitative inputs to ESG integration’s quantitative underpinnings. This might entail dialogue with a company to obtain a more intimate picture of its ESG performance or to encourage it to introduce better policies and practices.
Invesco’s view is that passive and active strategies alike can have a place in an ESG-aware portfolio. The majority of ESG investment types discussed earlier can now be employed across multiple asset classes – from equities to fixed income, from alternatives to ETFs.
“The majority of ESG investment types can be employed across multiple asset classes – from equities to fixed income, from alternatives to ETFs.”
From data to decisions – and beyond
The massive growth in ESG integration has led to a proliferation of assessment instruments and initiatives intended to help shape responsible investment decisions. They have emerged from a resolve to build a more sustainable global financial system, with asset managers keen to better understand how businesses are addressing ESG issues and asset owners keen to better understand how asset managers are responding to the continued rise of responsible investing.
Today, despite a degree of consolidation, there are still numerous such instruments and initiatives in operation around the world. They include ratings, scorecards, screening tools and stewardship codes. Many remain essential to the formulation of ESG-aware, data-driven investment decisions. The cause of responsible investing would be hugely undermined in their absence.
Yet they are not perfect. Often they best serve as signposts for further scrutiny and as guides for proactive engagement between asset managers and businesses. Data can tell us an enormous amount, but it cannot tell us everything.
For example, it is conceivable that a “bad” company, such as may be identified through negative screening, might be on the verge of a dramatic improvement in ESG performance – a turnaround that backward-looking, headline data alone would not necessarily reveal. Equally, a “good” company, such as may be identified through sustainability-focused screening, might be guilty of greenwashing – which is to say that it could be giving a false impression of its environmental credentials, perhaps through the deliberate supplying of misleading information. The truth is that the dividing line between “good” and “bad” assets frequently turns out to be blurred, which is why a blend of qualitative and quantitative insights can be useful.
It is also important to appreciate that the ESG integration journey need not end with the decision to invest. Reflecting the notion that responsible investing is a matter of long-term ownership and sound stewardship, engagement with companies and other investee entities is an enduring feature of many ESG investments. Whether through direct dialogue with senior representatives or via proxy voting at annual general meetings, this is how asset managers and their clients can use the power of active ownership to promote appropriate corporate governance and to make “bad” organisations better and “good” organisations better still.
Four key steps on the ESG integration journey
• Quantitative analysis
• Qualitative insights
• Holistic solutions
• Active ownership
“The dividing line between ‘good’ and ‘bad’ assets frequently turns out to be blurred, which is why a blend of qualitative and quantitative insights can be useful.”
Conclusion
In this article we have examined how and why environmental, social and governance considerations are incorporated into investment processes. We have seen how data underpins ESG-aware solutions and how quantitative insights can further inform them. We have explored why a “one size fits all” philosophy is ill suited to this sphere and how products and services are increasingly accommodating investors of all kinds. We have also explained how the ESG integration journey unfolds and how it can go on long after the decision to invest has been made – which reinforces our fundamental belief that responsible investing demands a long-term view and that a stakeholder-centric culture of ownership and stewardship should be at the heart of ESG.
Another vital factor in ESG’s trajectory is the rapidly evolving regulatory landscape, which increasingly compels organisations and investors alike to clearly demonstrate their awareness of ESG in their decisions. Landmark initiatives such as the European Union’s new Sustainable Finance Disclosure Regulation (SFDR) are at the forefront of this shift. We will discuss this issue in detail in our next article.
Footnotes
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1Active strategies: aim to outperform an index using manager skill and analysis. They tend to have higher charges.
Passive strategies: aim to match – not beat – the performance of a specific index. They generally have very low fees.
Investment risks
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Important information
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Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.
