ESG integration focuses on material risks that have an effect on company valuations. This is not about personal values, it’s about demonstrating value for investors.
Analysts and portfolio managers, from across the political spectrum, are paying attention to material risks in their investment process. Investing through the lens of ESG integration is for anyone—left, right, center—who recognizes that ESG issues are material risks and opportunities that affect our investments. Strong management of employees can result in lower turnover and higher productivity. Better relationships with the communities where companies operate can reduce the likelihood of lawsuits and operational disruptions. Water and waste efficiencies can reduce operational costs. It’s widely understood that companies impact the climate (through, for example, emissions and resource depletion) and the climate impacts companies (through, for example, operational disruptions and asset stranding). These are fundamental investment considerations where ESG information can offer insights.
The media focuses on company ESG ratings. But these ratings are not meant to be all things to all people. They are a starting point for further analysis. For passive investors, because the indexes that your portfolios may be built on are informed directly by ESG ratings, you need to understand what goes into them: what is being measured, how it’s being measured, and whether you agree with that approach. Some ESG ratings measure risk to a company’s enterprise value. Others focus more on how companies execute on ESG opportunities. Some focus on alignment to the Sustainable Development Goals (SDGs). Some measure net positive impact, weighing both negative and positive contributions to society.
For active investors, we need to be treating ESG ratings like equity analyst reports, not credit ratings. Active managers who have experience integrating ESG information do not simply use ESG ratings as is. They take in a multitude of ESG data i.e. all the underlying components of various ESG research providers (depending on the sector and company this could be metrics like employee turnover, supply chain programs, GHG emissions reduction programs, water intensity, etc.) and they map those data points to their own ESG materiality frameworks by industry.
The key here is to choose the manager that best aligns with how you view ESG risks and opportunities. Make sure that they have a consistent, intentional and repeatable process for incorporating this information, and that investment decisions are actually being made based on the process.
If stewardship (engagement and proxy voting) is important to you, make sure you know how the manager engages with companies on ESG risks and how they vote on ESG issues on your behalf.
Another approach to sustainable investing is values alignment. This can be done in conjunction with ESG integration or completely separate. A values-based approach is reflecting your own perspectives and beliefs and viewpoints in your portfolio. Every single person has different values. Put 50 people in a room and ask them what their values are and you’ll get 50 different responses. There are an increasing number of portfolio tools out there that will show you your exposure to areas like tobacco, guns, and fossil fuels. There are also tools to show you which investment products have explicit screens implemented to avoid exposures to certain areas.
We need to better differentiate between building portfolios around our personal values (values alignment) and creating value with our investments (ESG integration).
Tesla was recently dropped from the S&P ESG Index, and Elon Musk responded by tweeting that “ESG is a scam.” He even went on to tweet “I am increasingly convinced that corporate ESG is the Devil Incarnate.” The reason Tesla was dropped from the S&P ESG Index? The company’s weak handling of a federal investigation into multiple deaths linked to its self-driving cars, in addition to claims of racial discrimination and poor working conditions at its Fremont, California factory. Tesla has a notoriously poor record on labor issues (and corporate governance for that matter). Yes, the company makes electric vehicles and has contributed to a major positive low carbon shift in the auto industry. Yes, global carbon emissions will decline a result of the products Tesla manufactures. However, what gets lost here is the understanding that S&P’s ESG ratings look at more than just the environmental impact of a company’s product itself. There is also the “S” and the “G” to consider. And that’s where Tesla comes up short. ESG ratings don’t necessarily just look narrowly at the ESG risks and opportunities of the product or service the company provides, they may also be evaluating the ESG risks and opportunities within company operations and how they run their business.
While we’re on the topic, it’s important to point out that ESG is not about sorting companies into “good” or “bad” buckets and “cancelling” companies who are “bad.” As we continue to hear, there is a low correlation between ESG ratings companies. That’s a good thing—because investors who don’t agree with how S&P measures ESG have plenty of other ESG indexes to choose from that utilize different ESG ratings frameworks and data.