Finally – A Meaningful Deciphering of what “ESG Integration” Really Means

I get angry when an issue I care about passionately is reduced to meaningless jargon. I’m especially incensed when the issue has the potential to simultaneously save the planet and improve the economy. Fortunately, this time, I am in a position to make an impact and create change.

For decades, many investors and others have argued that environmental, social and governance (ESG) risks should be taken into account when investing. Many investors have believed that the risks and opportunities of climate change, executive compensation and other ESG factors are too big and too material to ignore.

A few years ago following the global financial crisis and faced with the challenges and opportunities brought on by the transition to a low-carbon economy, the asset management establishment began to catch on. Increasingly, asset managers began to say they “integrate ESG” in their investment process. Today, some $22.9 trillion is managed with at least some attention to ESG risks and/or opportunities.

The problem, however, is that “integrating ESG” has become a meaningless mantra. Firms were using “integrating ESG” to mean everything from mandatory consideration of the most sophisticated analysis to superficial greenwashing.

Investors lacked an analytical tool to understand how, when, where, by whom, and how significantly those asset management firms actually considered ESG risks and opportunities. Therefore, the Investor Responsibility Research Center Institute (disclosure: I serve as IRRCi’s executive director) commissioned Sustainalytics to do a deep dive into what “integrating ESG” really means.

Sustainalytics, an independent ESG research firm, developed a typology of how organizations use ESG. Do they use centralized staff or distribute ESG analysis responsibilities to the portfolio teams? Is ESG considered on a portfolio-company-by-portfolio-company basis, or more thematically, for instance looking at potential investments in the water sector? Is ESG research mandated to be considered, or just made available to the investment teams? Do the organizations modify external research or use it as is?

In all, Sustainalytics analyzed the approaches of 70 entities – 35 asset managers and 35 asset owners with nearly $20 trillion in assets. What they found was that – though there were a possible 64 different combinations of how organizations could integrate ESG across the dimensions – just six combinations were prevalent and prominent:

  • The Believer centralizes ESG research, usually around individual companies, and then compels the investment teams to use it. The Believer does that by imposing that research from the top of the organization down; for instance The Believer may screen out worst-in-class companies and not even consider them for inclusion in its portfolio.
  • The Cautionary also centralizes ESG research around individual companies and has methods to compel its use. But, unlike The Believer, The Cautionary integrates ESG factors at each portfolio team, focusing on using those ESG factors to understand company-specific risk.
  • The Statistician, like the first two types, also centralizes ESG research focused on individual companies and compels its use. But The Statistician is focused on research designed to unveil ESG factors that may affect future performance, and then uses quantitative techniques to create portfolios; for instance a low-carbon index fund which minimizes tracking error to standard indices such as the S&P 500.
  • The Discretionary centralizes ESG research, but there is no formal process to compel its use. The research is often unmodified third-party research about individual companies, and the portfolio managers and analysts have wide latitude as to how to weight that research or even whether to use it at all.
  • The Transition-Focused decentralizes ESG research, though there may be dedicated ESG specialists to assist portfolio teams, and the use of ESG factors is mandatory. However, unlike the first four types, that research is thematic. The Transition-focused makes those themes central to its risk and opportunity beliefs, examining such issues as water scarcity or healthy eating for risks and opportunities. An awareness of ESG is ingrained throughout the organization.
  • The Fundamentalist decentralizes ESG responsibilities, and the portfolio managers and analysts do not regard ESG research as separate from other forms of fundamental analysis. It focuses both on thematic and company-specific ESG research, and on both the risk and opportunity side of the portfolio analysis. The Fundamentalist rarely takes third-party ESG research as is, preferring to add its own research, often focusing on the financial materiality of specific ESG factors to specific firms.

As with any typology, not every investor fits neatly into one of these categories. But at least we now have the analytical tools and the vocabulary to discuss not just if a firm integrates ESG, but also to understand how its particular form of ESG integration affects its investment process and portfolio choices.

So, what kind of ESG investor are you?

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