How to align ESG intentions with results: an introduction to new Invesco research

Environmental, social and governance (ESG) strategies have seen massive inflows of capital over the past decade. Today, over one third of the world’s assets under management are ESG investments. And yet investors have little evidence that ESG investing accomplishes its purported goals. Nor do they have the information, tools, and methods they need to evaluate and communicate their specific ESG values, objectives, and preferences, much less to judge ESG performance.

A series of white papers highlight the challenges that ESG investors and portfolio managers face in implementing ESG investment mandates. These challenges are addressed with the end – the outcome – of ESG investing in mind. Because if ESG investing is to effectively make positive change, then outcomes matter.

Improving non-financial ESG reporting

The demand for more corporate reporting on nonfinancial information is on the rise from regulators, standard setters, investment trustees, and consumers. Yet the industry has yet to coalesce around measures that capture the nonfinancial benefits of ESG.

All investors can be defined based on their willingness to make tradeoffs between financial and non-financial returns. But investors cannot make trade-offs without knowing the quantity and quality of what’s being traded. Therefore, to elevate ESG as an investment objective on a par with return and risk, ESG factors that increase risk-adjusted expected returns should be differentiated from those that do not.

To be useful, issuer ESG reporting needs to be relevant, reliable, and relatable -- all of which are addressed in the reporting framework. In addition, solutions are proposed for standardisation – perhaps the biggest challenge for sustainability reporting by corporate issuers – and aggregatability.

The research also examines current attempts to improve ESG reporting and arrive at a solution that is clear, concise, aligned with investor objectives, and aggregatable into portfolio-level information, while leaving intact investor values, which are subjective, individual, and not standardisable.
 

R³: An intuitive tool for evaluating ESG performance

The heart of “The End of ESG Investing” is our proposed performance evaluation framework. R³ takes the Sharpe ratio, which captures risk and return, and adds responsibility – an additional term to the equation that allows investors to assess a portfolio’s ESG profile and to evaluate manager performance on this dimension. R³’s responsibility quotient is modified by an intensity factor that represents the weight, based on preferences, that an investor assigns to non-financial ESG goals.

To mitigate the vulnerability of the ESG quotient to manipulations such as window-dressing, R³ includes a transition measure that accommodates both ESG levels (“today’s virtue”) and ESG change (“tomorrow’s transition”), without taking a position on either. R³ also allows for ESG performance attribution to asset selection, security selection, and the interaction between asset and security selection. The research demonstrates all of these aspects of R³ with an example.

Developed more as a practical tool than as a rigorous model, R³’s advantages lie in its independent treatment of financial and nonfinancial components, its intuitiveness, and its generalisability to any measure of risk-adjusted performance. As a framework for investors to articulate their specific investment objectives, R³ is a major practical advance.
 

A more informative product template

“The End of ESG Investing” also proposes a concise, standardised ESG product template for investment strategies with nonfinancial ESG investment mandates. Our template includes 1) fund objectives, including nonfinancial investment objectives; 2) elements of the ESG investment process; and 3) measurable nonfinancial investment outcomes.

As an alternative to ESG information disclosure patterned on a “truth in investing” document, our one- to two-page template should serve the same function for nonfinancial objectives as investment performance reporting does for financial objectives. It reflects our preference for fewer rather than more metrics, based on measurability and materiality – cutting down on confusion, maintaining clarity, and avoiding the need to define a multitude of weights.
 

Our ultimate end

Doing good while doing well is here to stay. Our aim for “The End of ESG Investing” is to identify and acknowledge the gaps in sustainable investing and contribute toward elevating it to the same professional standard as that of traditional investing. If we succeed as an industry in applying the same rigour to sustainable investing that we have applied to traditional investing in the last 100 years, we will have helped investors to actually do good.

This research aims to help the industry apply the same rigour to sustainable investing that it has applied to traditional investing in the last 100 years.