Towards the effective integration of ESG issues into investment decision-making

Insight Investment’s four principles on how ESG factors may be applied to portfolio construction.

Since Insight established its responsible investment team in 2002, harnessing the team’s knowledge of environmental, social and governance (ESG) issues has been a key objective. Over the past seven years, and more intensively over the past three, we have integrated our knowledge of these issues into our investment analysis and decision-making for the different asset classes – equities, fixed income, multi-manager – that Insight manages.
Our experience has convinced us that investment returns can be significantly enhanced through the systematic analysis of ESG issues. However, delivering better returns is not simply a matter of doing great research, important though that is. The real challenge is to ensure that this research provides real value to our investment professionals. We believe that there are four principles that underpin effective ESG integration.
Principle 1: Integration begins with the investment process
In our view, ESG integration must begin with understanding the investment process for the specific asset class or funds in question, and whether and how ESG factors can be built into the particular investment process. Thus, attention must be paid to understanding:

o The needs of the particular fund manager or analyst, specifically their investment objectives and where and how ESG issues are relevant to these objectives.
o The issues that are already well understood by the market. While there may be limited investment value to be derived from focusing on topics such as tobacco litigation, themes such as outsourcing or human capital management may provide fertile areas for research and analysis.
o Investment time horizons. If fund performance is evaluated over relatively short time horizons, fund managers may be less interested in how longer-term issues such as climate change adaptation will affect the companies in which they invest.Principle 2: People are key
Insight recognises that analysts following different asset classes may have different views on whether the securities issued by the same company are good investments or not. Our objective is, therefore, to ensure that our views on specific securities – shares, bonds issued against different parts of a company’s capital structure – take account of the full range of analysis that our analysts or fund managers have done of the company.
At the day to day level, Insight’s research meetings (e.g. daily morning review meetings, stock and sector research meetings) are open to all, weekly updates on forthcoming research meetings are circulated to our equity, fixed income and responsible investment teams, the heads of the equity research, credit research and responsible investment teams meet monthly to review research priorities and ensure effective coordination of the research process, and where appropriate, joint meetings with companies are encouraged. Insight has an open access research system where research and other publications (e.g. company meeting notes, stock views) from the different teams is stored and can be accessed and reviewed by everyone. In addition, we conduct joint projects. For example, we recently established a working group to determine the investment implications of pension deficits. The group comprised Insight’s head of equity research, a credit analyst, an equity analyst with extensive knowledge of actuarial and valuation issues, and an analyst from the responsible investment team. The group identified several key metrics (including total gross liability versus market capitalisation, the date of the last actuarial review, the equity exposure of the pension fund, and the manner in which pension fund liabilities are accounted for) that could be used to identify companies of particular concern. We now use these metrics to analyse pension fund deficits in a consistent manner across our investment portfolios.

Principle 3: ESG issues can be material… but not all the time
Over the past few years, there have been many cases where ESG issues have significantly affected company cashflows, balance sheets and reputations. Examples include government legislation in areas such as waste and water management, economic incentives such as the European Union’s Emissions Trading Scheme for greenhouse gas emissions, and tobacco litigation. We believe that understanding how these issues impact on long-term returns (specifically, companies’ return on invested capital) is critical to making good investment decisions and to delivering the long-term returns that our clients require.
However, the fact that some ESG issues are material should not be interpreted as an argument that all such issues are material. While there is no universally agreed definition, financial analysts frequently use numerical thresholds – five percent of a company’s revenue or five percent moves in a company’s share price are common rules of thumb – to assess the financial materiality of a particular issue. Using these thresholds, the vast majority of social or environmental issues – notwithstanding examples such as tobacco litigation and climate change – are simply not material. Moreover, time horizons are critical. While climate change adaptation, for example, is clearly a huge issue for society, with potentially enormous financial implications for companies and their investors, the time horizons over which it will play out is beyond conventional investment time horizons.
Principle 4: ESG performance may not be a good proxy for corporate risk
Our view is that the quality of management of ESG issues can provide important insights into a company’s ability to identify and assess the significance of wider business risks and its ability to effectively respond to and engage with stakeholders. In addition, we believe that companies that manage these issues effectively are likely to be better investments over the longer term.However, ESG performance is just one of a whole series of factors that investors consider when making investment decisions. Investors do not consider a company’s ESG performance in isolation but rather how it may affect cash flow, revenues, profits and, hence, return on capital. For example, while some commentators have argued that investors should preferentially invest in companies with lower greenhouse gas emissions, prudent investors will also assess the likelihood that the company will be required to reduce some or all of its greenhouse gas emissions, the timeframe over which emissions reductions are likely to be required and the cost to the company of taking action to reduce its emissions.
In conclusion, we want to emphasise that responsible investment is about two things. First it is critical that ESG issues are systematically integrated into the research process. Second, acknowledging that many companies have been sceptical of the assertion that investors do take account of ESG issues in their investment decisions, it is essential that investors actively engage with companies both to set out their expectations of how issues such as climate change should be managed, and to explain exactly how these issues are taken into account in their investment analysis. That is, ESG integration is not a stand-alone activity but rather a central element of a holistic approach to responsible investment that encompasses comprehensive analysis of ESG issues, actively promoting high standards of corporate behaviour, explaining to companies how ESG issues are built into the investment process, and playing a supportive role in wider debates on corporate governance and corporate responsibility.

Rory Sullivan is Head of Responsible Investment and Sandy Black is Head of Equities at Insight Investment. This article is based on a report, ‘ESG Integration: Facing the Challenges’, published in July 2009. Link to report