Investing

ESG integration unpacked

16 September 2020 | Posted by Anna Panayi
creativity

Do good with your money.

What’s it all about?

ESG integration is a strategy that combines ethical considerations related to risk and opportunities with traditional financial analysis to make investment decisions.

Why should you care?

ESG funds and indexes are outperforming their non-ESG counterparts. According to a study by Morningstar (2019), over the last 10 years, 58.8% of surviving sustainable funds across categories defined by Morningstar were considered to beat their average surviving traditional peer.

Capital is at risk.

What will you learn?

In this pack, you will learn about what ESG is, how it works and what to consider if you want to start investing.

What is ESG integration?

ESG is an acronym for the environmental, social and governance practices of an investment. ESG Integration is the strategy that combines the ESG-related risk and opportunities, with traditional financial analysis to make investment decisions.

The traditional financial analysis of a company is called fundamental analysis, and it looks at the company’s financial statements, its competitors, the market it operates in and the economy at large. ESG takes the fundamental analysis further by providing a more comprehensive understanding of the future opportunities and risks of a company.

ESG integration is an attempt to incorporate ethical and social concerns into portfolios. While there is an overlay of social consciousness, the main objective of ESG valuation is still financial performance.

It is possible to give ESG scores to individual companies, investment funds or entire markets.

Today, ESG investing is estimated at over $20 trillion, or around a quarter of all professionally managed assets around the world. Increasingly ESG funds and indexes are outperforming their non-ESG counterparts.

How does ESG integration work?

ESG integration is about including companies and industries with relevant high ESG scores in your portfolio—a form of positive screening.

ESG rating agencies rate the ESG credentials of a particular company or fund by looking at how the company’s policies, plans and disclosure perform against environmental, social and corporate governance standards.

Typically, ESG rating agencies use publicly available information such as annual reports, websites, CSR reports, stock exchange filings and news sources. Each agency will have its own way of converting this information into digestible data that they can analyse and turn into an ESG rating.

Each agency will also have its own ESG rating scale. For example, one might rate on five risk categories from negligible to severe while another may use the ‘AAA to CCC’ rating system similar to how credit rating agencies assign risk ratings to institutions that issue bonds.

It is common to find a further breakdown of scores within the three main ESG components to provide additional insights, we discuss this below.

What to consider when making your ESG integration decisions

There are three distinct components to ESG ratings, so it is possible to consider companies that score highly on one or more of the ESG components that are important to you. Each ESG rating agency will focus on different aspects that could make up each component, which we will discuss below.

As you read about each ESG component, reflect on what is important to you, and what you will want to look out for in ESG ratings for the investments you are considering.

Environmental

The environmental component relates to the company’s impact on the Earth, in both positive and negative ways.

Agencies may rate policies, plans and disclosures related to some or all of the following considerations for their environmental score:

Climate change
Carbon footprint
Water consumption
Waste management
Recycling
Energy consumption
Air pollution
Water pollution
Deforestation
Biodiversity
(use of) Renewable energy
(use of) Green products, technologies, and infrastructure

Social

The social component relates to how companies treat people and the contribution it makes to society. In other words: how the company treats its employees, customers, consumers or others in their supply chain.

Agencies may rate policies, plans and disclosures related to some or all of the following considerations for their social score:

Labour standards – including pay, benefits, perks, training and development
Health and safety – including sexual harassment prevention
Diversity and inclusion – in hiring, salary and access to promotions
Stakeholder/community relations
Human rights
Ethical supply chain – responsibly sourced products that avoid child-labour or conflict-free minerals
Public stance on social justice issues
Data protection and privacy

Governance

The corporate governance component relates to the running of a company. In other words: the quality and robustness of a company’s internal structure and practices.

Agencies may rate policies, plans and disclosures related to some or all of the below for their governance score:

Independence of the board
Board structure – including the diversity of the board
Management team – including the diversity of the team
Executive compensation – including bonus related to performance, perks or payouts upon exiting the organisation.
How management make decisions
Separation of Chairman and CEO roles
Shareholder rights
Shareholder communication
Conflicts of interest
Whistleblower schemes

Reviewing the full (but not exhaustive) list above, you’ll note lots of overlap between the considerations with each ESG category. ESG rating agencies decide how they classify the areas of concern – often resulting in 3-5 categories within each component.

Sustainability

From an ESG perspective, sustainability describes the features which ensure companies, industries or markets can operate within their means and remain stable over the long term. Sustainability is achieved when economic performance intersects with high ESG ratings.

Conclusion

It has never been easier for you to invest ethically using ESG ratings. An increasing number of companies and funds are beginning to report on their ethical credentials. But as we discussed, there is no one agreed way of rating ethical investments, so making comparisons is difficult. And unfortunately, some companies exaggerate or misrepresent their ESG and ethical credentials; known as ‘social washing’ or ‘greenwashing’.

Research is essential for accurately determining whether an investment or group of investments align with your values, especially when investing in a fund such as a stocks and shares ISA or pension fund.

Where to get ESG investments?

Once you have done your ESG research, you can pick up an investment product from an online stock broking service or platform, through a financial adviser, through a bank or building society, a broker or directly from a fund manager.

Key Takeaways

ESG is an acronym that means the environmental, social, and governance practices of an investment.
While there is an overlay of social consciousness, the main objective of the ESG integration strategy is still financial performance.
An increasing number of companies and funds are beginning to report on their ethical credentials – making it easier to make ethical investment decisions.
Research is essential for accurately determining whether an investment, or group of investments, align with your values, especially when investing in a fund such as a stocks and shares ISA or pension fund.

capital risk warning.

When investing, capital is at risk. Your investments can go up or down and past results are not a guarantee of future returns.

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