Hope you are having a great week and welcome back to our brief thoughts on ESG. This week I’d like to talk about how ESG integration looks like.
According to PRI, integrating ESG factors into the analysis of public equities is the most widespread responsible investment practice in the market today. In a nutshell, what this means is that during the due diligence process for any equity investment, you add a layer of analysis where you consider both potential risks and potential benefits arising from a series of environmental, social, and governance factors.
The first step towards integration will be to define the level of commitment the fund will have with ESG. There are funds that are more biased towards environmental goals, others that are closer to social impact themes, others that prioritize corporate governance standards (which we would argue has been the nearest and dearest to the financial industry for a long time), or funds that commit to a mandate that combines any of the above. In reality, the sky is the limit when you define your objectives. Some funds even sell a commitment to sustainability that may impact financial returns, whereas most will focus on delivering both returns and ESG integration.
Once the mandate is clear, the next step would be to find relevant sustainability information. This is easier in some markets (like Europe) than others (like Mexico). The goal is to assess the objective impact different ESG factors may have in the company’s outlook as well as the risk that certain traits may pose. There will be qualitative factors to assess (like management’s credibility or reputation, or even the perception the market may have of the company’s commitment to their sustainability strategy and their alignment of interests) as well as quantitative factors (like carbon emissions, ESG scores or ratings and their recent trends, etc.). Both can be integrated into financial models through explicit assumptions or things like discount rates, fair multiples, etc.
Finally, after investment decisions are made (buy the stock, sell the stock, hold the stock), there is also a final and very relevant step to us that has to do with questioning and providing feedback to management teams. Sometimes investors underestimate how deep an impact this step may have on the company’s strategy and future endeavors. It will also be relevant to be a responsible shareholder if the decision was to buy the stock. This means voting when votes are required, being present or represented in shareholders’ meetings, and voicing concerns.
How common is ESG integration globally today?
- The CFA Institute and PRI published a series of reports after they surveyed 1100 financial professionals and ran 23 workshops in 17 countries. In EMEA, around 40% of equity investors and 33% of fixed income investors incorporated ESG factors in its analysis. In the US, less than 20% of portfolio managers and analysts systematically include material ESG issues in their analyses and that less than 10% adjust their models based on ESG information.
- According to a report from the Global Sustainable Investment Alliance, sustainable investing assets in Europe, the US, Canada, Japan, Australia, and New Zealand stood at US$31 trillion at the start of 2018, a 34% increase in two years. In the same report, they report the largest sustainable investment strategy is negative or exclusionary screening (65% of AUM), followed by ESG integration (57%), and corporate engagement or shareholder action is the smallest (32% of AUM).
- Looking forward, Bank of America believes ESG funds will see an additional US$20 trillion of inflows over the coming two decades.
What is going on in Mexico?
ESG integration is just starting to gain some traction in Mexico with one of the big AFOREs (Mexican pension funds) appointing an internal resource exclusively dedicated to it (Afore SURA, 4th largest by AUM according to data from CONSAR as of January 2020). Since AFOREs manage north of US$214.5 bn overall, the future of ESG integration in Mexico lies in the decisions the big players take regarding this issue.
There also exist a couple of funds with a more advanced level of ESG integration locally managed by AM Advisors and Actinver. We would expect this to grow over time and spread into the traditional funds too as their investors ask for it (especially in funds with foreign investors that commit to adopt better ESG practices).
Naturally much of this ESG integration in the investment process is complex. ESG itself is a broad subject and trying to come up with an overall single ESG score for subjects as diverse as corporate governance and environmental sustainability is often disingenuous. Unless explicit weights are given to each objective of financial returns and ESG, it’s not easy to work out the right trade off between such different goals. In addition there is a key difference between negative screening (taking out companies that do ESG harm like oil companies) and positive screening (including companies that do ESG good such as a water company).
Hope this was of use. As usual, if there is anything we can help you with, please reach out. Also, don’t forget to recommend any ESG subject matter that you would like us to research and put in a forthcoming weekly
Partner, Miranda ESG
Contacts in Miranda Partners