This post comes after a much-needed break. It takes up from where the previous post left off, where we discussed five ESG strategies financial institutions (FIs) adopt - screening, thematic investing, best-in-class approach, momentum-based investing, and impact investing.

Here, we talk of the sixth one - integration. This deserves a deeper treatment than the others because it is one of the most impactful and holistic, but also the hardest to implement among strategies.

A new lens

ESG integration is the systematic and explicit inclusion of material ESG factors into investment analysis and decisions¹. Traditionally, these factors were either simply not considered, overlooked or considered as an afterthought in financial analysis, and portfolio construction and management.

We’ve come a long way from there. As I’ve discussed in my October post, ESG has demonstrable impacts on the risk exposure, returns, customer base and reputation of FIs and corporates alike.

Leading FIs that integrate ESG in their decision-making use financially material ESG data as a new lens to identify previously unpriced risks and opportunities, often in conjunction with discussions with the senior management/Board of the investee/borrowing company.

¹  https://www.unpri.org/listed-equity/esg-integration-techniques-for-equity-investing/11.article#:~:text=The%20PRI%20defines%20ESG%20integration,alongside%20thematic%20investing%20and%20screening. 

The process

Typically, FIs follow three stages in their integration model.

Stage 1: Qualitative analysis – FIs gather relevant information from multiple sources (including but not limited to company reports and third-party investment research and ESG scoring agencies) and identify material factors affecting the company.

Stage 2: Quantitative analysis – FIs assess the impact of material financial factors on securities in their portfolio(s) and investment universe and adjust their financial forecasts and/or valuation models appropriately.

Stage 3: Investment decision – The analysis performed in stages 1 and stage 2 leads to a decision to buy (or increase weighting), hold and monitor (maintain weighting) or sell (decrease weighting).

Integration techniques

• Fundamental strategy: Fundamental investors build or modify company valuation models to assess a company’s fair value by using its data to make assumptions about future performance. This fair value is then compared to the current share price, which enables them to identify companies that may be over- or under-valued by the market. ESG factors are integrated into financial forecasting exercises to reflect risks and opportunities arising out of ESG and its potential impact on market share and sales.
  
  For e.g., improved worker well-being and satisfaction in the apparel sector is expected to have a positive effect on sales and cash flows through a motivated work force and better brand. Or, a carmaker may stop selling a particular type of car in country X due to environmental concerns, and that is estimated to reduce sales by X% annually.
  
  Investors can also make assumptions about the influence of ESG factors on future operating costs and either adjust them directly, or the operating profit margin.
  
  For e.g., a manufacturing company’s operating margin may be reduced to reflect the loss in production/closure caused by high injury and fatality rates, or poor health and safety standards, or community protests. Or, a thermal company’s operating cost estimates may increase by Rs X crore annually for the additional cost associated with a new legislation on air pollution.
  
  Similarly, FIs must also consider the impact of physical climate and transition risks of their portfolio and appropriately factor it in to assess the fair value of an asset.
  
  For e.g., as per RBI’s database², banks are exposed to over INR 856 crores of outstanding credit in the Joshimath area which has been affected by land subsidence as per the recent news.
  
  

² https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!19

• Quantitative strategy: As some ESG data points become more standardised, statistically accurate and comparable, quant managers globally are harnessing ESG data (alongside other factors such as value, size, momentum, growth, and volatility) using mathematical models and statistical techniques to outperform their benchmarks.
  
  Integrating ESG factors into quantitative models could follow one of two approaches.
  
  The first involves adjusting the weights of securities ranked poorly on ESG to ‘zero’, based on research that links ESG factors to investment risk and/or risk-adjusted returns (for example: positive correlation between good ESG ratings and returns vs negative correlation between ESG ratings and stock volatility)
  
  The second involves adjusting the weights of each security in the investment universe according to the statistical relationship between an ESG dataset and other factors (for example: a company with low fundamental risk but high product safety issues could lead to shrinkage of maximum allowable position size).
  

• Smart beta strategy: Here, ESG factors and scores can be used as a weight in portfolio construction to create excess risk-adjusted returns, reduce downside risk and/or enhance the portfolio’s ESG risk profile. In one of the case studies provided by Principles for Responsible Investment (PRI)³, AXA Investment Managers reported that it adjusts the weights of stocks in a global equity universe to increase the exposure to companies with high profitability, high quality of earnings, low-risk profiles and top ESG scores.
  
  To illustrate, all stocks in the starting universe are passed through four filters, covering desired factor exposures (earnings quality and low volatility) and undesirable risks (speculative value and financial distress). Each filter is awarded a score, all of which are then combined into a single score for each company.
  
  Next, in order to maintain diversification, a weighting scheme is designed to avoid skewness to large corporations, which is then integrated with ESG scores of the particular stock. Note, in the example below, Company A and B have the same filter scores and market cap with only their ESG scores being different.
  

³ https://www.unpri.org/listed-equity/a-practical-guide-to-esg-integration-for-equity-investing/10.article

• Passive (indexing): The market for responsible investment indices has grown steadily since their launched 25 years ago. Currently, most major index providers offer them. This is driven by factors including low costs, evidence of the relative benefits of passive versus active investing, and new financial products such as exchange-traded funds.
  
  Passive ESG funds rely on third-party ESG indices to screen companies for their compliance with different E, S and G criteria. They choose companies whose ESG scores are above set thresholds. ESG fund managers then build a portfolio of investments that track the index’s performance.
  
  For example, the iSTOXX Europe 600 SD-KPI is based on the mainstream STOXX Europe 600 index. All 600 components of the parent index are included, but are over- and under-weighted according to Sustainable Development Key Performance Indicators (SD-KPIs).
  
  The SD-KPIs are selected according to the three most relevant ESG indicators to business performance for 68 different sectors defined by investors and analysts. Each stock is allocated a SD-KPIntegration score between 0 and 100, based on the stock’s performance on the sector-relevant SD-KPIs and based on the score, the stock is under- or over-weighted based on its weight in the parent index.
  
  However, this approach has a few limitations that investors must be aware of, and address.
  
  Apart from the fact that the ESG scores vary between rating agencies, index-based strategies also lead to skewed exposures to large corporations and certain sectors. Even in CRISIL’s 2022 ESG scoring exercise, we observed that within listed companies, 50% of large-cap were in the ‘leadership’ and ‘strong’ categories, as against 25% of mid-cap. Only about 10% of small-cap were in the strong category (none in leadership) and ~90% fell in the ‘adequate’ and ‘below average’ categories. This was primarily due to poor disclosures from the mid- and smaller-sized companies.
  

In terms of sectors, as much as 50% of the Nifty ESG India index comprises information technology and financial services companies. This has certain downside risks.

For e.g., the recent shift towards energy stocks and disruption in tech companies globally have eroded shareholder value. A more nuanced approach to index construction would thus offer greater benefits than a blanket screen.

Some investors also create custom benchmarks, either internally or through service providers, to incorporate their specific ESG criteria.

In the next post of this series, we will cover the seventh and final ESG strategy used by FIs, viz., active ownership.