ESG* integration – Do most asset managers only pretend? Voluntarily or involuntarily?

There is a lot of “ready to use” ESG score providers in today’s market. Many investors buy these externally produced ESG scores, but what do they do with the scores? Some report the fund ESG profiles based on these scores, at least when they have a high enough coverage. But to what extent is ESG integrating being properly practiced? It is probably to quite a low extent…

Let’s first have a look at what ESG integrating is.

According to EFFAS – ”ESG integrating defines practices by traditional financial management that take environmental, social and governance factors into account throughout the investment decision-making process.”

Notice here two points; ”take into account” and ”throughout”, let’s dig deeper into this.

ESG integration point one – ”Take into account”

As most buy ready made ESG scores, how can you take these into account?

Well the ESG score can be used as an indicator of ESG risk/opportunity remaining after the company has addressed the initial exposure of the company’s activities. So combining the traditional financial analysis with the ESG Score (an indicator of the risk/opportunity level of the extra-financial elements analyse) this is considered ”taken into account” by many. But how should this really be practically done? How do you weight in the ESG score here? Many investors do not even get to this level of question; they pretend they do ESG integration and hide behind their expensive contracts with ESG scoring providers. And some of the ESG score providers publish not less than 4 different indicators per company, absolute and relative to different sub groups of peers. Hold on to your hat when trying to integrate this in a simple and resource scarce process.

How should ESG factors properly be taken into account?

The investors need to go deeper to really be in a position to properly take the ESG factors into account. The ESG score is just the starting point, it should raise flags. If the score is low (here meaning high ESG risk), this should be a reason for digging into the details for E, S and G. Where does the weakness come from? And to really be able to pinpoint the ”problems” the investor need to look into the details within each of the three factors (E, S and G).

ESG integration point two – ”Throughout the investment decision-making process”

An investment process consist of several steps and to satisfy the ”throughout” throwing a glance on an ESG score for a company when taking investment decisions is far from enough.

Both the ESG risk and the ESG opportunity should come in at different stages of the investment process.

The ESG opportunities have a great focus among portfolio managers today; it is easy to identify. If a company sell equipment benefiting from the global trend to ”go green” for instance, many foresee good growth and higher valuation. So E opportunities are often well ”integrated” in the P&L estimates. But most ESG factors are actually about risk. To what extent are these taken into account? They should also be taken into account when judging the investment case. How do you do that? Well you can risk adjust the sales and cost estimates; this is typical for Environmental and Social factors, but not exclusively. You can also adjust the required risk premium for the investment; this is typical for Governance problems, but not exclusively. There are many models here, some only do P&L adjustments for ESG risks and opportunities and some prefer to do this at the level of required risk premium. And some combine without taking the same factors into account in double, hopefully.

So do asset managers pretend? And is it voluntarily? The excuse and is it valid?

Some pretend while knowing better, but many do not have enough knowledge of what ESG integration requires. Even if the first is worst they are both problematic and signals of urgent action. If you work for an investment manager, where do you and your company belong today?

ESG integration is new for many and needs to find its way. I agree, the point is to be on the way. But no excuse for not knowing what is required. So it may be a valid excuse that this is new, but the plan to delivery must be ready within very short. Today it may well pass, but clearly not tomorrow as asset owners are getting more and more demanding.

What does it take to get to proper ESG integration?

A thorough review of the investment processes and the changes that needs to be implemented is required to get to real ESG integration. The ”integration” part in the existing investment processes is the easiest, and the preparation of the ESG integratable factors is the most work demanding part. This is as described above, the work to go deeper and identify the ESG risk and opportunity and estimate the P&L and risk premium requirements impacts.

Some hurdles of real ESG integration

  • Misunderstood use of ready to use bought ESG scores, a sleeping pillow
  • Lack of understanding of what ESG integrating means
  • Lack of understanding of how ESG integrating can be done
  • Lack of understanding this is part of fiduciary duty
  • Increased work load for existing employees
  • Lack of will to integrate the shorter term financial factors with the longer term ESG factors (extra financial)
  • And more…

Let skip the ESG integration? No longer an option…

Well, if you wish to stay in business, this is not really an option.

Most practitioners realise it is part of the fiduciary duty of an asset manager. The EU regulation is also pushing in the direction for ESG integration.

So if you do not yet practice real ESG integration or plan to start it within short, wake up and tune in!

*Environmental, Social and Governance factors