ESG integration is good but no longer enough

ESG investing entails researching and factoring in environmental, social, and governance issues, in addition to the usual financial considerations, when evaluating potential investment cases. ESG investing is also a stakeholder-centric analysis, which gauges how companies treat all their stakeholders, not just their shareholders, in the perspective of long-term success or failure.

Combining the ESG lens with more traditional security financial analysis is known as ESG integration. ESG considerations go hand-in-hand with long-term thinking, the essence of robust portfolio management and advisory services.

ESG integration is a must

It’s no wonder that ESG investing is gaining traction. Research is showing that ESG investing can reduce portfolio risk, generate competitive investment returns, and help investors feel good about their investment holdings. Furthermore, the focus on ESG policy within the EU and the associated regulatory initiatives puts non-financial considerations on a level playing field with financial considerations: Definitively a landmark change in investment approach.

But every investment strategy also has risks. ESG investing is no different. Above the traditional pitfalls that short-term financial markets dynamics could have on the relative performance of ESG integration, the lack of standards and questions around data quality or subjectivity are the most commented and obvious weaknesses.

Misconceptions, mis-selling and misunderstandings are also relevant considerations. The feel-good sentiment can only be solidified, if accompanied by proper disclosure and transparency. While ESG integration, undoubtfully useful for assessing investment case robustness, is nevertheless not the holy grail of sustainable investment. ESG integration, on a stand-alone practice, should not be considered as the investment revolution supporting the transition to a more sustainable model.

The market shifted away from the practice of excluding investments that don’t meet ESG criteria, to an active integration of investments that do. While this is a definite sign of progress, it still isn’t enough.

But ESG integration is not a panacea

Over the past decade, we have witnessed a growing number of investors who are incorporating ESG criteria into portfolio management. Today a large number of asset managers use “ESG integration” to describe their overall approaches to responsible, sustainable or ethical investing. The market shifted away from the practice of excluding investments that don’t meet ESG criteria, to an active integration of investments that do. While this is a definite sign of progress, it still isn’t enough. We must be proactive to ensure that investments seek to have a positive impact and act as active owners.

While ESG integration is part of the toolbox and necessary if we are to re-shape our world, it is insufficient alone. Above everything, investors should understand (and advisors should make it loud and clear) the limitations of different asset classes they invest into when it comes to having an impact. Secondary market purchases of stocks and bonds simply constitute private exchanges, not cash issuance for companies. The impact of disinvestment from ESG laggards will have a limited (if any) impact on the cost of capital of the concerned company for as long as the company doesn’t need to access capital markets.

If the ambition of the investor is to shape a brighter future, it is worth considering additional sustainable and responsible investment practices on listed equities. ESG integration doesn’t presuppose investing for positive change. The only way to have significant positive impact in listed equities is for investors to use their influence to steer companies to make their impact more positive. As shareholders, we also have the power to influence company strategies by using our voting rights and by engaging with companies to encourage improvement.

As shareholders, we also have the power to influence company strategies by using our voting rights and by engaging with companies to encourage improvement.

Engage (for equity and bonds) and/or deny (for bonds) are complementary (for now)

By the nature of the instrument, an equity is perpetual. A seller is replaced by a buyer (sometimes the company itself). New capital fundraising happens in debt markets far more often than in equity markets. It’s this bond issuance that’s often used to finance new capital projects and large borrowers are more likely to refinance rather than repay debt. Closing the ‘cash tap’ via debt denial on companies not delivering enough on the sustainability roadmap could have direct impact on the funding cost of concerned companies. Dialogue and engagement should also lead bond issuance to be more conditional on ESG targets. Bond covenants (tools used by lenders to place additional terms upon borrowers) typically address financial ratios but we could expect new standards related to purpose bonds, a new generation of bonds address climate change mitigation or social considerations by embedding ESG covenants. In that prospect, in December 2020, Eni (the Italian oil & gas major) announced amendments with its banks to contracts underlying almost €4bn of existing debt in order to attach new conditions to meeting some specific UN Sustainable Development Goals (SDG 7 and SDG 13). This means that this debt will trigger a bonus/malus mechanism for investors, depending on whether or not sustainable performance objectives have been met.

Investors can play a big part in achieving what we see as the ultimate goal of a resilient, sustainable economy. As investment professionals we also need to be transparent and humble enough to facilitate this transition, helping investors minimize the risk of legitimate frustration potentially coming from the lack of clarity. ESG integration is a necessary condition to support the transition toward sustainable finance. But ESG integration in isolation is not enough.

The exercise requires more efforts and ambitions, if the purpose of investing is to create a virtuous cycle by allocating capital to those companies that create the greatest societal returns. This is nothing more than the social responsibility of investors to help advance our society. This is the legitimacy of capital markets.

ESG integration should not distract from incentivizing and enabling companies to deliver greater and more material progress when it comes to social and environmental issues.

ESG integration should not distract from incentivizing and enabling companies to deliver greater and more material progress when it comes to social and environmental issues. ESG integration is good but no longer enough.