What is ESG integration in sustainable investing?

As our transition to a low-carbon, more sustainable world accelerates, you might hear that ESG is the answer to the environmental and social challenges we face. But many of us are still unsure exactly what ESG means. Is ESG integration in sustainable investing a winning strategy for both investors and the planet? And – what does ESG actually imply in terms of on-the-ground environmental and social action?

At Kearney Group, we’re passionate about sustainability and see the great potential ESG presents for investors and the citizens of the world alike. In this article, we’ll help you decode the acronyms and deep dive into what ESG really is, what it really isn’t, and how it can help you do good with your money, whilst also generating investment returns.

What is “ESG”?

“ESG” is a world of corporate performance data that helps us account for the environmental, social and governance behaviour of a company or investment. It’s one of those terms that most recognise, but not everyone understands.

ESG reflects a company’s:

• environmental performance, like its carbon emissions and the amount of water used;
• social factors such as gender, race, diversity and inclusion; and
• governance factors such as corporate risk management, tax and reporting practices.

The term was first coined by the United Nations Environment Programme Finance Initiative in their October 2005 Fleshfields Report.

These days, ESG integration is generally regarded as one of the basic building blocks of a sustainable investment strategy.

What is ESG integration in sustainable investing?

“ESG integration” is the systematic and explicit inclusion of environmental, social and governance (“ESG”) performance data in an investor’s analysis and decision-making process. It provides a framework that helps us account for the externalities of a company or investment. And in turn, it gives us a more comprehensive picture of an investment’s real current and future value, and its risks. In this way, ESG factors are effectively our canary in the coal mine; highlighting leading companies, and helping us identify the laggards.

Today, ESG integration is central to sustainable investment strategies as it’s a powerful tool to de-risk portfolios and identify future performers, and thus, improve investment performance.

This makes intuitive sense when you consider the companies and management teams who are actively mitigating ESG risks and capturing ESG opportunities; they are, generally speaking, the highest quality and most skilled teams across the board.

Many great management teams have always actively managed key ESG issues. Doing so is just good business and reduces corporate risk. For example, reducing your company’s carbon emissions not only helps mitigate climate change, it also reduces your cost base and your risk of future climate change-related litigation.

Other companies have simply chosen to ignore ESG performance or decided against disclosure, despite the overwhelming arguments in favour of doing so. For some, ESG has been regarded as more of a “greenwashing” communication issue, than a value-adding strategy.

As a result, high quality ESG data and reporting has been hard to come by. And, that which has been available is far from standardised, making it difficult to compare apples for apples, so to speak.

As investor interest in ESG has grown, however, so too has demand for data and ESG rated investments. So, we’re now seeing great improvements in the quality of reporting and global standards beginning to emerge.

Consumer demand and the overwhelming evidence showing that strong ESG performance is linked to better investment results, has put management teams, boards and financial markets on notice. ESG integration is here and it’s not going away any time soon.

What ESG integration isn’t.

It’s equally important to understand what ESG isn’t as herein lies the opportunity for investors to create a more powerful and holistic sustainable investment strategy.

ESG is not an exclusion strategy.

Exclusion strategies rule out certain types of investments if they fail to meet predetermined moral or ethical standards and/or ESG criteria.

For example, ethical investors commonly exclude tobacco, weapons, and gambling companies to refine their investment universe.

It is important, however, to understand that ESG integration alone doesn’t ensure your portfolio is invested in companies that are either avoiding doing bad, or actively doing good.

ESG is not an inclusion strategy.

Secondly, integrating ESG factors into an investment process doesn’t automatically lead to companies with only excellent ESG performance making it into a portfolio. It just means ESG factors are actively considered within the investment process. Companies with mediocre ESG performance may still be included in some ESG integrated portfolios if their traditional (non-ESG) performance is excellent.

ESG doesn’t account for business purpose.

Thirdly, ESG integration doesn’t take business purpose into account. This is a really important consideration that many investors overlook.

For example, the purpose of a renewables company may be to help accelerate the transition to a low carbon world, whilst a tobacco company’s purpose may be to create the high quality tobacco products its customers are demanding. However, these two companies may have the same consensual ESG score because business purpose has been ignored.

ESG doesn’t guarantee on-the-ground impact.

And finally, ESG integration doesn’t necessarily translate into on-the-ground impacts. Impact is defined as intentional and measurable social and environmental returns which are not just valued in financial terms.

For example, a technology company may help to alleviate poverty in developing countries by donating internet access to people who can’t afford it. The social impact of this strategy may be extraordinarily high, but that same company may not perform well on ESG factors because its governance may be weak.

So there’s no direct connection between strong ESG performance and on-the-ground impacts, and vice versa.

Given all of the above and what we now know ESG integration isn’t – consider this your prod to dig a bit deeper if you want to do good with your investments.

As an investor, how do I bridge the ESG gaps?

There’s clearly a wide gap between ESG integration and making the world a better place. So what should you do to ensure your investments align well with your values?

Firstly – seek specialist help. Explicitly ask your financial advisor how your investments are managed and dig for the answers.

Work with advisors who are constructing portfolios that leverage the risk-reducing benefits of ESG integration, in combination with additional strategies and screening techniques like:

• Exclusion screening – to ensure your portfolio is not exposed to companies which are causing harm.
• Inclusion screening – to ensure your portfolio is exposed to companies with strong ESG performance, and are benefiting from the opportunities created by being sustainable, socially progressive and well run.
• Ethics/norms-based screening – to ensure your portfolio is not exposed to companies operating below a minimum ethical standard.
• Corporate engagement – to signal to company boards the importance of ESG performance and catalyse management action.
• Impact investing – to create measurable and intentional impacts, directly linked to your investment.

Whatever you do, don’t forget ESG integration by itself simply isn’t enough for either your portfolio or for the state of the planet. However, there are many powerful strategies that can be combined to create high performing sustainable investment portfolios.

Seizing the ESG opportunity.

At Kearney Group, we believe that sustainability and the current ESG boom is just the beginning of a much longer game which will play out over the coming decades.

By investing in an ESG integrated portfolio, you have the compelling opportunity do good with your money.

If you’re interested in a more sustainable investment portfolio, get in touch.

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