Internet searches for environmental, social and governance, or ESG, increased fivefold since 2019 as more people turn their attention to issues of climate change, social justice and equity and the risks they pose to the planet and portfolios.
It’s not just individuals. Global management consulting firm McKinsey & Company reports that more than 90 per cent of S&P 500 companies now publish some type of ESG report, and some countries are introducing mandatory ESG reporting requirements. A new International Sustainability Standards Board has already issued two proposed global sustainability standards.
All of this focus has also led to a backlash. Critics are calling ESG a distraction and point to how difficult it is to define let alone measure. Plus, there is no well understood link to performance.
For asset owners and particularly long-term investors, it’s difficult to know what to believe. “There is so much information – too much information – when it comes to ESG and it has led to confusion,” says Tamara Close, founder and managing partner of Close Group Consulting, ESG strategy specialists for capital markets.
When it comes to ESG and making investment decisions, Close says a good starting point is to understand the difference between ESG themed investment funds and ESG integration. For example, an ESG themed fund might invest exclusively in renewable energy companies taking a specific environmental lens to investing. ESG integration is a core concept that means you are looking at all the factors that affect a company’s performance, including “E”, “S” and “G”.
“Just because something is called ESG does not mean it is ESG integrated,” says Close.
“ESG integration is about increasing the aperture of the lens you look through when assessing an investment. It’s about expanded risk management and due diligence beyond traditional considerations. It is not about giving up financial returns. It’s not about screening out companies or excluding certain sectors. It’s not about impact investing either. It’s really about doing a deep dive when assessing any company you are looking to invest in.”
One approach is not better than the other, and they aren’t mutually exclusive. As well, ESG is not necessarily relevant for every investment strategy. For example, if you are invested in a quantitative, high-turnover fund where decisions are based on specific algorithms, the manager is likely not considering ESG issues.
However, if you have an actively managed public equity portfolio that has 20 to 30 stocks and a long-term time horizon, then that manager should be considering ESG risk, says Close.
“Some reports say 80 per cent of a company’s value is now based on intangibles and most of these can be ESG factors. It’s important to assess your current portfolio and understand the material ESG risks it faces,” says Close.
“The next step is to find the level of ESG risk you are comfortable with. Once you’ve done this assessment of your current holdings, then you may decide to put a certain portion in an ESG themed fund to reduce, for instance, environmental risk. Or, you may decide to reduce ESG risk across the board.”
Close recommends asset owners focused on the long-term ask three key questions of their asset managers to ensure they are integrating ESG risk in their assessment of existing and potential investments:
What are the top ESG risks for the fund?
Depending on the nature of the portfolio and the investment strategy, the answer will either be high level and systemic – climate change, or equity, diversity, inclusion for example – or specific at the company level. “Managers who are doing a deep dive should be able to give you precise information on each of the companies in your fund. There should never be more than five to eight material ESG issues for a specific company,” says Close. “If it’s a passively managed fund with 200 stocks, this won’t be possible.”
How did you identify them?
Close recommends asset managers start by using general sector and industry frameworks, such as the Global Reporting Initiative and the Value Reporting Initiative, to identify ESG risks. They can then go deeper and conduct company and business model specific assessments from a stakeholder point of view. “ESG issues are dynamic in nature. The frameworks don’t update as frequently as we’d like them to. It’s important to know managers are conducting these assessments on an ongoing basis,” she says.
What are you doing about them?
This is key. “You can have some fund managers who have comprehensive ESG assessment methodologies but that information doesn’t make it into the investment decision,” says Close. “As an asset owner you want to make sure they are mitigating the risks as much as possible and at the same time leveraging any opportunities.”
Final thoughts
Close’s best advice to asset owners: “Think of an ESG assessment as a comprehensive risk management exercise similar to assessing any other material risk for an investment. Soon ESG will be priced into the market. Now is the time to get ahead of it.”
PBY Capital Limited is registered as an exempt market dealer and an investment fund manager with Canadian provincial securities regulatory authorities, servicing family offices and their professionals. For more information, visit: www.pbycapital.com.
This story was created by Canadian Family Offices’ commercial content division, on behalf of PBY Capital Limited. The opinions and information provided in this article are solely those of the writer and are not to be construed as personal, legal, accounting, taxation, or investment advice, or as an endorsement of any entity.