In my previous two posts, I covered what ESG is all about and what it isn’t, and the right reasons to practice ESG.

We will now explore the ideal ESG investment strategy. A gap still exists between the theory of ESG and the actual implementation for both financial institutions and corporates.

Financial institutions globally deploy the following strategies to incorporate ESG in their decision-making:

Exclusionary screening

By far the most common, this strategy is used to exclude companies, sectors or countries from investment considerations based on pre-defined negative filters. Sectors such as tobacco, gambling, adult entertainment and weapon manufacturing are generally excluded given they adversely affect human health or are considered unethical or immoral.

In their investment universe, many financial institutions exclude companies that derive more than a certain percentage of revenue from these sectors.

Financial institutions are feeling the heat to align with the Paris Agreement (aims to limit global warming below 2 degrees Celsius) and Net Zero targets. Thus, scope 3 emissions i.e. financed emissions have taken centre stage. To meet these targets, various global investors are excluding sectors such as thermal coal (generation as well as services essential to fossil fuel extraction), oil sands and shale oil/gas from the investable universe. Some financial institutions have also begun to exclude fossil fuel companies without a strategy/roadmap for decarbonisation and/or transition to clean energy consistent with the Paris Agreement.

That said, Russia’s invasion of Ukraine has made investors reconsider their stance on excluding weapon manufacturers, given the defence industry’s role in national security and protection of basic human rights.

Negative screening is also being applied to companies with the lowest ESG scores, usually provided by third-party agencies.

A common criticism of the ‘exclusionary screening’ strategy is that it tends to exclude financially profitable companies if they are in a ‘negative’ sector. For example, companies in the tobacco sector have consistently outperformed the benchmarks.

Therefore, a more nuanced approach to ESG investing is being taken where things are not seen as black and white. Companies in the so-called ‘negative’ sectors can be included if appropriate engagements to improve their ESG performance can be demonstrated (we will discuss this strategy in part 2).

Positive screening

This strategy involves actively including companies from sectors considered the least carbon-intensive (but not necessarily performing well on social metrics).

These sectors include BFSI (banking, financial services and insurance), information technology (IT) and related services.

A close look at the constituents of most ESG funds or indices in India reveals a high bias towards such sectors.

As much as 50% of the Nifty ESG India index comprises IT and financial services companies.

Such an approach has certain downside risks. For example, the recent shift towards energy stocks and disruption in tech companies globally have eroded shareholder value. A more nuanced approach to ESG investing will offer greater benefits than a blanket screen.

To put this in perspective, as on October 31, 2022, on a 5-year basis, Nifty 100 ESG TRI outperformed Nifty 50 TRI by 100 basis points. That said, if we look at last 1-year return, Nifty 100 ESG TRI fell 0.8%, while Nifty 50 TRI rose 3.32%. Similarly, as on November 29, 2022, If we look at 1-year time horizon, average return of ESG funds in India was ~2%, while return on Nifty 50 index was 10%.

Thematic investing

Positive screening can also be applied to various other environmental and social benefits that companies provide.

Companies in the waste management or water treatment space or those with a sustainable or healthy product range could be selected for their specific problem-solving/ opportunity-generating abilities.

In industry parlance, this is called thematic investing, wherein financial institutions take a call on the prospects of an overall sector or theme based on macroeconomic, geopolitical and technological trends.

These shifts are not short-term in nature, but long-term, structural and transformative.

Best-in-class screening

This strategy is a subset of ‘positive screening’. Here, financial institutions invest in companies that are leaders in their sector in terms of ESG scores or meeting certain ESG criteria.

Investors that follow the best-in-class principle do not necessarily exclude ‘negative’ sectors, such as thermal coal or alcohol. They instead invest in the companies that make the most effort to meet the ESG criteria for their respective industries.

This strategy, which does not blatantly exclude energy-intensive sectors, may be more relevant for a country like India due to its huge development and energy security needs.

The strategy also rewards the companies that are helping in the transition to a sustainable planet by investing in renewable energy, rather than depriving them of the capital to make the transition.

ESG momentum

Another subset of ‘positive screening’ is picking companies (regardless of their industries) with demonstrable advancement in ESG performance over the years and room for further improvement.

As per a Société Générale S.A. study, 30 names that enjoyed positive momentum on their ESG ratings generated cumulative outperformance of 23.5% versus the STOXX600 from March 2013 to January 2019.

This was much higher than the outperformance of the top 30% of ESG rated stocks from each sector (+9.4%), or that of the negative-/neutral-momentum ESG stocks (+6.1%).

Clearly, ESG is not only a risk management strategy but also a source of alpha.

Impact investing

This strategy involves investment directed towards a specific target or environmental/ social outcome.

Global Impact Investing Network defines impact investments as investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.

Impact can be defined as the final effect that an action produces on beneficiaries, an effect that has been sought in advance and responds to a clearly identified issue.

More commonly, microfinancing to low-income sections of the society features in this type of strategy.

Impact investments have three characteristics: intentionality, additionality, and impact measurement.

• Intentionality of the investors is the fact that they identify a cause to be solved through their investments. For example, affordable housing or healthcare.
• Additionality means that the provision of funding by the investor enables the impact to be achieved, and that without it, the desired effect on the beneficiaries would not have been possible.
• Impact measurement involves elements of measurement, which are not always easy to characterise according to the nature of the project. In the case of microfinance, it is the number of people who have become financially independent thanks to the microloans granted.

In part 2 of this post, we will cover two more ESG investment strategies, namely ESG integration and active ownership — these are the most impactful and holistic of all the strategies but the hardest to implement.

With contributions from Darshan Savla, Senior Research Analyst - Industry Research, CRISIL Market Intelligence & Analytics