ESG* risk mitigation – Modern ESG* engagement versus limited traditional engagement
All investments have ESG risks and other risks, we could just call it risks as there is no real reason to distinguish between these in the end. Asset managers are professional risk takers and know how to price this. We will focus on the ESG risk separately in the following though.
ESG risks are new and twofold
ESG risks are new in the meaning that we have a better understanding of the “full” set and mechanisms of ESG risks today than before. The twofoldness is reflected through double materiality, what directly impacts the company (outside-in) and what impacts the company indirectly through the impact of the company on the world around it (inside-out to outside-in).
Let us presume that all agree to this, which is not a wild assumption. In the following, we will discuss how asset managers should move from limited old-style to modern full blown ESG engagement in the optic to reduce investee company ESG risk.
The limited traditional and typical engagement on ESG factors
Engagement is not new to investors and traditionally this has mainly been about two things, Corporate Governance (part of the G in ESG) and Severe Controversies (can be under E, S or G in ESG). Both of these are addressed for companies that an investor already owns where something relative to these aspects has happened. But also, as an investment strategy for activist investors considering they can create value by investing and then making a company improve on these aspects.
Interestingly, for the first 150 companies we have ESG researched we also see this in the G contribution to the total absolute ESG score, it is clearly tilted a little higher than for the E contribution and the S contribution. Higher here indicates lower ESG risk.
Engagement on these factors should of course continue and risk professionals will. Companies are at large good at communicating corporate governance information and severe controversies are not difficult to identify through press and other news wires like Bloomberg and Reuters. That said, it is time to broaden and deepen the engagement approach along the better understanding of the full ESG factor risk spectrum.
The full-blown modern engagement on ESG factors
As investors get to understand the full content of a fundamental ESG research report, they will notice that the ESG risk profile of an investee company is the sum of a potential long list of subsegments of E, S and G. Therein are also smaller controversies that may not reach all portfolio managers’ screens. The limited old-style engagement may cast a shadow over these, also for companies not having any corporate governance issues or severe controversies, as they may too early be ticked off as companies with no ESG risk for the wrong reasons. This is where ESG ratings, or ESG scores as we prefer to label is at sustainAX to avoid any amalgam with credit rating, come in. The sum of many small ESG risks identified by the ESG analyst can in some cases be bigger than important controversies. Of course, the materiality of ESG risks plays an import role here.
Let us exemplify this. For an ESG risk analyst, a full fundamental ESG research can take at least a day or two depending on the mass of ESG relevant communication published by a company. A large number of sub elements are risk assessed for a given investee company. Let us say, to simplify, that the ESG analyst assesses that for each and one of these, there is a remaining ESG risk of 50%. A company would then come out with an ESG score of 50. As this is the middle of a scale from 0 to 100, by error most investors consider this is “ok” and take no further action to engage. This is a mistake, as the company still has an important job to do to reduce the residual ESG risks. And investors should tell them. In reality, it is more complex, as companies will be good in ESG risk mitigation in some areas and less in others. This implies that the company can be much worse in some specific areas than the 50% total remaining ESG risk in the example above, meaning that the reason to engage is larger.
What can these risks be that the traditional ESG engagement does not capture?
These can be divided in two different groups, the risks identified through historic company ESG performance data and the forward-looking assessment of ESG risk mitigation action.
Examples of the first group can be “% of employees taking part of collective bargaining”, “% personnel turnover” and “% of temporary employees”. This are risk assessments based on what we call Corporate ESG Data that can be read directly out of the company reporting. An important point here is that just having these data points is not the same as understanding what risk level they represent. The latter is important to understand if you think CSRD in Europe means there is no longer need for ESG risk analysts.
Examples of the second group are assessments of green initiatives, climate risk mitigation, management systems whether it is for health & safety, quality, suppliers, etc. This is what we call ESG Research Data, and these are ESG risk assessment based on company narratives and more complex information structure, these cannot easily be read out of the company reporting for an untrained eye.
More about different ESG data types and their use here: https://www.sustainax.com/index.php/2023/02/12/sfdr-different-types-of-esg-data-and-why-you-will-always-need-the-fundamental-esg-analyst/
So, here over we have just some examples from a much longer list of ESG risks that do not naturally come to the surface and that require a job to identify. This is what the ESG risk analyst is doing.
How to get the modern ESG engagement process going?
With a broader and deeper set of ESG risks identified and assessed, a job of prioritisation must be done. A fundamental ESG risk report may raise a large selection of questions pointing to different ESG risks that should be addressed. Many of the questions are related and within the “same” sub area of E, S and G risk factors. A good ESG risk analyst will consider the materiality for a specific company that is based on the activities the company in question has. This should be reflected in the ESG risk research report and surfaced in the conclusion and section suggesting the most important areas and topics to target for engagement.
Should the ESG research report not contain these elements specifically, the provider can help by showing how to get to this.
What is the outcome of moving from traditional to modern ESG engagement?
With better understanding of the ESG risks, an investor will no longer only engage on corporate governance issues and severe controversies, but on a much broader and deeper selection of ESG risks.
For both Equity and Credit investors, this is a nice way to mitigate the total risks of the portfolio. It is particularly interesting for Credit investors where the job is to a large extent avoiding downside risk at the wrong price.
Investors that have ESG score improvement as an alpha generating strategy are the best in this area. They buy companies with low ESG score reflecting high ESG risk where they consider they can help the company starting to mitigate ESG risks and obtain a higher ESG score reflecting lower total ESG risk. The lowest hanging fruits here are the “black box” companies not communicating at all on ESG.
Conclusion on ESG Engagement the full-blown modern way
Savvy investors having understood this are already practicing modern ESG engagement of course and there are a lot of free riders as all will benefit from a company’s more successful ESG risk mitigation. What the free riders should realise though is that if they also join the modern ESG engagement wave, the pressure on companies to really make changes to reduce their ESG risk will increase drastically, and results should come faster.
So, it is really a no-brainer to pick up the ESG research report of your holdings and at least bring the 3 most material questions to the next meeting with all the companies in your portfolio even for those with no corporate governance issues or severe controversies as these two only represent some parts of the potential ESG risks.
What do you think?