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ESG considerations in investment analysis

While governance matters have long received their due importance, environmental and social issues have received slower traction. ESG refers to a combined framework of ‘environmental, social and governance’ factors—which relate to phenomena such as scarcity of natural resources, climate change, global economic and demographic change, etc. While these considerations have traditionally been qualitative and intangible, there is a shift towards quantification.

Sustainable investing

Sustainable investing (also called responsible investing) refers to investment in companies that have sustainable business models i.e. which manage their financial, environmental, and human capital resources efficiently. ESG investing refers to investing in line with ESG considerations. Socially responsible investing refers to investing in companies which are not detrimental to a society, but which contribute towards positive societal change through their positive social and environmental profiles.

ESG implementation approaches

At one end, value-based investing adds ESG consideration on top of traditional security analysis, while on the other hand, values-based investing screen/filter companies based an investor’s values/beliefs. In between these exist the specific implementations of ESG such as:

Negative screening

Negative screening (also called exclusionary screening or norms-based screening) excludes companies that do not meet the ethical/ESG standards of an investor.

Positive screening

Positive screening, typically implemented using an ESG scoring approach, selects investments if they have a minimum required ESG scores.

Best-in-class screening

Best-in-class screening selects investments with the best ESG score in each sector weighted in accordance with some benchmark.

Full integration

Full integration refers to explicit inclusion of ESG factors into traditional security analysis.

Overlay/portfolio tilt

Overlay/portfolio tilt involves use of certain strategies to achieve particular ESG characteristics for a portfolio. Risk factor/risk premium investing includes ESG information in determination of systematic risk.

Thematic investing

Thematic investing focuses on investing in a specific sector or theme such as energy efficiency.

Engagement/active ownership attempts to achieve targeted social/environmental objectives along with measurable financial return, often through active/direct investment. Examples include green finance, green bonds, etc.

Catalysts for ESG growth

Catalysts for ESG growth include (a) significant losses incurred by some companies due to their ESG lapses, such as BP Plc for environmental concerns due to Deepwater Horizon, Walmart for HR policies, Volkswagen for unlawful emissions; and (b) focus of long-term institutional investors, called universal owners, on long-term sustainable growth due to their seemingly perpetual time horizon.

There has been significant growth in assets under management (AUM) dedicated to consideration of ESG factors. Different organizations such as Global Sustainable Investing Alliance (GSIA) collect information about assets subject to ESG consideration. There is also an increased focus on additional ESG disclosure, for example, the Global Reporting Initiative (GRI) prepares a sustainability reporting framework, Sustainability Accounting Standards Board (SASB) prepares sustainability accounting standards.

by Obaidullah Jan, ACA, CFA on Wed Feb 26 2020

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