Why and how should investors take ESG criteria into account?

27TH March 2023

Executive summary:

ESG, i.e. the implementation of environmental, social and governance criteria into investment decisions, is increasingly important for investors. It allows them to reduce financial risks, but also to seize growth opportunities related to the ecological and social transition. Indeed, companies that take ESG factors into account are less exposed to non-financial risks, such as reputation, politics or regulation. They are also more resilient to external shocks, such as natural disasters or health crises, because of their upstream assessments. Investors who use ESG filters benefit from a reduction of risk on their portfolios, thanks to a better diversification and a selection of often innovative securities. Responsible investment is not limited to avoiding risks related to ESG issues, it also allows finding investment opportunities in areas that would not have been valued on the simple analysis of their economic results. Thus, investments in companies in the fields of renewable energy, circular economy or social inclusion can be wise investment choices, meeting the growing demand of consumers and investors for more inclusive products and services. The rest of the article explains concretely how to take these criteria into account, apply them and measure them within an investment structure.

For many years now, investors have known that they can no longer rely solely on financial indicators to evaluate the value of a company. It is essential to take into account environmental, social, and governance aspects to have a comprehensive view of the company in which an investor wants to invest their money. This is basically the now-called ESG.

This term is not new. Back in 1960, the concept of Socially Responsible Investment (SRI) was created in order to tackle both social change and financial returns for investors.

The term ESG was first mentioned in 2005 in a UN study commissioned by its Secretary General at the moment, Kofi Annan, entitled ‘Who Cares Wins – Connecting Financial Markets to a Changing World.’ The report presents a set of recommendations aimed at promoting the integration of ESG factors into investment decisions and encouraging a long-term vision of value.

According to the 2019 Global Investor Study by Schroders, which surveyed 25,000 investors worldwide, more than 60% of those under 71 years of age believe that all investment funds – not just those explicitly defined as sustainable investment funds – should take sustainability factors into account when doing investments.
Therefore, it seems that this notion is becoming increasingly important in 2023. This article will answer the questions of why and how to implement an ESG strategy.

I) How important is ESG for investors?

A) ESG reduces financial risks related to environmental, social, and governance issues.

Implementing environmental, social, and governance (ESG) criteria into investment decisions reduces the financial risks associated with these issues. Indeed, companies that take into account ESG factors are less exposed to non-financial risks such as reputation, politics, or regulation. They are also more resilient in the face of external shocks, such as natural disasters or health crises, due to their upstream evaluations. Moreover, investors using ESG filters reduce risk in their portfolios, thanks to better diversification and a selection of often innovative securities.

Indeed, many companies have had reputation problems that have led to a sharp drop in their total value. For instance, take the example of Uber, it got accused of multiple violations of social and labor rights, such as driver exploitation, sexual harassment, discrimination, or tax evasion. Uber faced several lawsuits, boycotts, and demonstrations in different countries, and its stock value fell by nearly 40% between its 2019 debut and late 2020.

By taking into account the social value of the company, Its investors could have identified this weakness and thus better considered their investments.

B) ESG allows investors to capture growth opportunities related to the ecological and social transition.

Responsible investment is not limited to avoiding risks related to environmental, social, and governance issues. It also makes it possible to find investment opportunities in areas that would not have been valued on the simple analysis of their economic results.

Thus, an investment in a company in the renewable energy, circular economy, or social inclusion sectors may not always seem like a wise investment choice at first glance. However, according to studies by the American consulting firm McKinsey or the World Economic Forum, these companies:

– Respond to the growing demand from consumers and investors for products and services that are more environmentally and socially respectful.
– They often better optimize their operating costs through the use of natural resources, recycled materials, or by improving their energy efficiency. Thus, Unilever, for example, has saved $1 billion since 2008 by proactively reducing its consumption of water, energy, and materials. The water and energy-saving measures implemented by 11 companies in KKR’s portfolio have generated $11 million in annual savings since 2019.
– Such actions also promote employee loyalty and motivation.

According to a Bain & Company survey, 60% of the funds have a formalized ESG policy, 57% have increased their ESG resources in the past three years, and 75% have integrated ESG into their due diligence process. The survey also shows that 70% of funds have an ESG reporting system for their holdings, but only 30% use standardized key performance indicators (KPIs).

Therefore, having an ESG policy based on KPIs seems to be a good method to differentiate oneself from brands, customers, or LPs.

Expert calls for ESG investments

II) How to implement an ESG policy at each stage of the investment process?

A) By defining the policy and investment objectives of your fund

Defining the policy and objectives is the first step in the ESG integration process. It involves establishing the general framework and strategic directions of the investor in terms of responsible investment. It is recommended to clearly define the following elements

– The scope: this is to specify the scope of ESG implementation, i.e., the asset classes, markets, sectors, or themes involved.
– The principles: this is to define the values, norms, or frameworks that guide ESG integration, such as the Principles for Responsible Investment (PRI), the Sustainable Development Goals (SDGs), or the Paris Climate Agreement.
– The motivations: this is to explain the reasons behind implementing ESG, whether they are financial (improving risk-adjusted returns), ethical (aligning investment with mission or vision), or regulatory (complying with legal or contractual obligations).
– The performance indicators: this is to choose quantitative or qualitative measures to evaluate the effectiveness and impact of ESG integration, such as the average ESG score of the portfolio, the reduction of greenhouse gas emissions, or the number of engaged companies.
– The expected reports: this is to determine the frequency, format, and content of reports on ESG integration, as well as the recipients and channels of dissemination.
– It is also important to communicate the policy to internal and external stakeholders to strengthen the investor’s credibility and transparency. Internal stakeholders include executives, employees, and internal committees, while external stakeholders include clients, beneficiaries, regulators, and the public.

Finally, it is recommended to regularly review the policy based on financial market developments, ESG issues, or stakeholder expectations. The review may involve internal or external consultation to collect feedback or suggestions.

An example of a well-defined and communicated ESG integration policy is Norges Bank Investment manager, the Norwegian sovereign wealth fund, which publishes its responsible investment policy on its website. This policy covers all investments whether in listed or unlisted equities. It is based on three principles: respecting its obligations as a responsible shareholder, contributing to sustainable development, and managing its financial risk effectively. It also explains its financial and ethical motivations, its integration methods, and its expectations of companies.

Private equity firms can leverage senior advisors who can assist them due to their past experiences – in case needed when defining this roadmap.

B) By using extra-financial analysis methods based on ESG criteria.

Once your criteria are defined, you must seek to implement them in your investments. For this particularly, several methods exist:

– ESG rating involves assigning a total or dimensional score (environmental, social, and governance) to each company based on its performance on relevant ESG criteria. This score can be used to compare companies to each other or to a benchmark index, or to exclude companies with a score below a defined threshold.
– ESG scoring involves assessing the financial impact of ESG factors on the fundamental value of each company, taking into account the risks and opportunities associated with these factors. This score can be used to adjust the company’s financial valuation model, by modifying the discount rate, growth rate, or future cash flows for example.
– ESG relative weighting involves modifying the weight of each company in the portfolio based on its relative performance on ESG criteria compared to other companies in the same sector or country. This technique aims to overweight companies with better ESG performance and underweight those with poorer ESG performance.
– ESG-optimized weighting involves optimizing the portfolio based on financial and ESG performance objectives, using mathematical algorithms. This technique aims to maximize exposure to ESG factors while respecting portfolio constraints (risk, return, diversification, etc.).

These methods are not exclusive and can be combined to strengthen ESG implementation in extra-financial analysis. An expert call can provide with the information to obtain effective and rapid assistance on the best method to adapt according to the investment structure.

Conclusion

In conclusion, the implementation of ESG criteria into investment decisions has become essential for investors due to the many benefits it provides. On one hand, it helps to reduce financial risks related to environmental, social, and governance issues by evaluating the resilience of companies to external shocks and avoiding companies with a poor reputation. On the other hand, it offers investment opportunities in areas such as renewable energy, circular economy, or social inclusion, which meet the growing demand for more environmentally and socially responsible products and services. Investors must therefore take these criteria into account to have a comprehensive view of the company and choose sustainable, profitable, and long-term investments.