In recent years, we have seen an increasing number of asset owners and managers integrating ESG research into their investment decision making. Aside from driving capital towards sustainable companies, ESG analysis enables a more wholistic understanding of the risks associated with an investment opportunity. As discussed in the first installation of this series, ‘It’s Not Easy Being Green Part 1: Choosing A Direction’, an important building block for integration of ESG factors into the investment analysis process is careful data procurement. Lack of ESG reporting standards and the myriad of ESG scoring techniques make thoughtful data procurement and a thorough understanding of the ESG market essential to ensure information is valid, consistent, and aligned with an investor’s goals. Once this foundational step is taken, asset managers and owners can begin to shape how they will capture and analyze ESG risks.
Define Your Measurement
A critical step in integrating ESG factors into the credit analysis process is defining what role ESG will play in assessing performance. In the SEC’s April 9th risk alert ‘The Division of Examinations’ Review of ESG Investing’, they specifically highlight how, in some cases, lack of a clear measurement definition has increased confusion in the industry. “The variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisors and funds have not clearly and consistently articulated how they define ESG.” Clearly stating this definition helps determine the context in which ESG metrics will be measured and, in turn, informs investors’ decision making at each step in the integration process to help ensure consistent application of ESG integration techniques in accordance with the definition. As ESG integration in equity analysis is more commonplace, many organizations’ measurement definitions focus on topics important to equities, such as how company ESG metrics can drive share prices. However, as investors’ strategies are extremely diverse, so are ESG measurement definitions. While definitions generally center around the financial materiality of ESG topics, each investor must tailor their definition to highlight the specific aspects of financial materiality they want to focus on.
For example, when analyzing institutional cash portfolios loaded with commercial paper, government securities, and other fixed-income investments, a different set of ESG metrics may prove to be more useful. Capital Advisors Group’s prioritization of liquidity and principal protection has shaped our definition of ESG such that we look to measure company performance on environmental, social and governance factors that can materially affect the creditworthiness of an investment holding. Therefore, defining which aspects of ESG exposures you are measuring will provide guidance for later steps in the ESG integration process.
Focus on the Important Things
Once the context of ESG analysis has been defined, the next step should be choosing which ESG topics are material given the investor’s measurement definition. ESG research can take into account dozens of material factors that vary depending on the industry or type of business being evaluated. Examples or material factors include carbon emissions, packaging material waste, and energy consumption when assessing a firm’s environmental performance; human capital development, community relations, and health care when assessing social performance; and ownership control, pay scales, transparency, and ethics when assessing governance. As outlined in Russell Investment’s research paper ‘Materiality Matters’, company performance on these material ESG topics is a far better indicator of overall performance than company performance on immaterial ESG topics. Maintaining a focus on material factors reduces noise, keeps the analysis focused on what matters, and ensures precise outputs. Clear identification of these material topics has the additional benefit of ensuring clients and managers are on the same page as to what factors are incorporated into the research and portfolio management process. This discrepancy information was cited as a challenge in the SEC’s April 9th risk alert.
However, the number of material ESG topics to be considered varies greatly by industry and company. While these material topics will often overlap with traditional financial performance metrics, one of the goals of incorporating ESG topics into the credit analysis process is to capture a broader universe of risk factors that will more accurately reflect the true risk exposure of an investment. As a result, material ESG factors are often supplementary or tangential to the information traditionally reported by companies.
The addition of material ESG topics into the credit analysis process can leave investors wondering which of these topics they have perhaps been implicitly monitoring for years, but now need to explicitly identify in order to capture the risks they present. ESG data providers and sustainable reporting organizations such as MSCI and SASB regularly update published materiality maps highlighting which key topics they deem material to various sectors and sub-sectors. These maps can provide a foundation for an asset owner or manager wishing to not overlook any material ESG exposures. However, material topics should be further refined to account for each investor’s definition of materiality, and the composition of their investing universe. Careful selection of material topics is critical to the successful integration of ESG factors into the credit analysis process, as it lays out the areas on which performance will be measured.
Quantify the Impact
After identifying which topics are material to the ESG analysis process, the potential impact of these material topics can be quantified. As not all of these topics will affect investment performance equally, it is important to understand the nature of a topic’s impact. Capital Advisors Group considers time and scale to be the two main factors to consider when evaluating a topic’s impact such that. These can be interpreted as follows:
- Time Horizon: A shorter time until the topic impacts a company will render it more material.
- Scale: The larger the impact of a topic on a company will render it more material.
Using a simple but well-defined set of principles, investors can create a detailed guide to quantifying how material each topic is to a peer group. This consistent basis for evaluating materiality ensures uniform application of the measurement principles across an investor’s universe, thus avoiding inconsistencies and data discrepancies.
As asset owners and managers further integrate environmental, social and governance factors into their investment process, they must ensure proper consideration is given to what they are attempting to measure, what factors they are using to do so, and how their impact is quantified. These considerations are critical to the ESG integration process. A hasty undertaking of them can result in wrongful representation of ESG-related risks, which in turn can misdirect investment decision making. Done correctly, this process should serve as a solid foundation on which an ESG Scoring Methodology can be constructed, which will be the topic of the third installment of this series.