ESG integration – why it matters

While it is clear that more stringent regulation can encourage companies to improve their governance, optimise their environmental management and better meet their social responsibilities, it has become increasingly important for all investors to understand the impact that their financial decisions can have on society and the environment.

Like many other banks, Banque Internationale à Luxembourg (BIL) factors environmental, social impact and governance (ESG) considerations into its decision-making. This is why BIL has established a flexible ESG integration framework that applies across the bank’s portfolio management and investment services, setting out its intentions and what investors can expect.

This framework is not set in stone, and it is updated regularly. BIL is aware that responsible investment practices are changing all the time, as more information becomes available and scientific thinking evolves. Its aim is to remain agile and responsive in the face of these shifts.

ESG integration

In building the ESG integration framework, BIL thoughtfully uses well-defined criteria to address various aspects of sustainability. Environmental considerations are those related to the conservation of the natural world: carbon emissions, energy efficiency, waste management, pollution, biodiversity and water scarcity. Social impact considers people, including relationships and social cohesion, as well as labour standards, a company’s relationship with its workforce and the community, gender and diversity, education and childcare.

None of these aims can be advanced without good governance. This involves setting out best practice and standards for managing and administering a company, including board composition and independence, the management structure, audit processes, remuneration, compliance policies to prevent complicity in bribery and corruption, whistleblower procedures, and tax practices.

It is tempting to believe that these factors are just ‘nice to have’. In reality, they can significantly impact companies’ financial results and their long-term value. There are financial risks associated with environmental mismanagement – legal regulatory penalties, for example – as well as financial risks arising from a company’s reputation and its social licence to operate. These may be harder to quantify, but they affect a company’s ability to operate effectively and profitably.

A practice followed by many investment managers has been to draw up forecasts from a company’s financial metrics and superimpose ESG factors on top. BIL’s approach, however, is to incorporate environmental, social impact and governance factors at an early stage in its analysis in order to ensure better-informed investment decisions.

Deciding exclusions

There will be areas where sustainability practices are so inadequate that it precludes investment, even in profitable companies, for which BIL maintains an exclusion list. These include certain individual companies, barring investment in either their bonds or equity. It may also extend to certain countries, notably those that are subject to economic sanctions.

For example, BIL excludes companies that derive more than 10% of their revenue from thermal coal. It is the most carbon-intensive and least efficient method of generating electric power from fossil fuels, and also releases a wide range of other pollutants into the environment.

The bank excludes companies involved in the business of what are described as controversial weapons, those that have indiscriminate effects and cause disproportionate harm, including their development, testing, maintenance and sale. It also excludes any company that violates the United Nations Global Compact Principles on human rights, labour rights, the environment, or corruption and bribery considerations.

ESG analysis

Says BIL ESG Product Manager Alejandra Encinas: “As part of our ESG integration, we use scores to mark individual companies. This guides us on where to invest and where not to invest. Companies are graded from A to E on their environmental risks, with A signifying excellent and E poor.”

“We invest in companies with the highest scores and eliminate the worst players in each industry, without demonising entire sectors. This integration helps us identify companies that are better equipped to address ESG factors and related challenges, and to leverage opportunities related to sustainability and responsible business practices.”

As part of this analysis, the Investment Office at BIL examines five core areas:

• • Climate change. This explores a company’s adaptation and mitigation roadmap to decarbonise its business activities. How does it plan to deploy renewable energy and contribute to the transition toward a climate-neutral economy?
  • Resource depletion and waste management. How effective is the company in scaling up waste reuse and recycling capabilities, to mitigate the impact of its business activities on ecosystems, preserve biodiversity and transition toward a circular economic model?
  • Digitalisation and innovation. How successful is the company in harnessing opportunities to achieve greater industrial and resource efficiency through innovation and digital technology, while protecting data privacy and supporting strong and resilient digital networks?
  • Healthy living and wellbeing. To what extent is the company actively investing in human capital through job creation, gender equality and working conditions, as well as research and development, and universal access to healthcare?
  • Demographic shifts. Is the company preparing for the requirements arising from an ageing population or the demographic boom in some emerging countries, fostering an inclusive economy and quality of life?

At each step, access to sustainability information is crucial, although this has become far easier in recent years as companies collect and publish more data. This will potentially increase under the requirements of the EU’s Corporate Sustainability Reporting Directive.

In compiling ESG ratings for individual companies and making sure that any new information is incorporated, BIL currently uses a number of third-party providers such as Refinitiv. Refinitiv holds a comprehensive suite of ESG data, analytics and insights, and has a large ESG database, covering, as at the time of writing this article, over 85% of aggregate global market capitalisation across more than 630 different metrics.

The bank also currently uses Morningstar Sustainalytics, whose Global Standard Screening qualitatively assesses companies’ compliance with the United Nations’ Global Compact Principles, identifying businesses violating these principles or at risk of doing so.

Portfolio construction

ESG integration comes with investment management considerations because there are likely to be differences between sustainability-focused and conventional portfolios. For example, fossil fuel companies can at times generate substantial and regular dividends, so excluding them can affect the balance of a portfolio and the structure of investment returns.

The differences can be seen in the make-up of ESG indices – the MSCI World ESG Leaders benchmark has double the weighting in Nvidia, Microsoft, Eli Lilly and Alphabet than the standard MSCI World index. Apple, Amazon and Meta are not among the top 10 constituents of the ESG Leaders index, but are substantial components of the main index. The implications of ESG for investor portfolios, and their associated risk/reward profile, needs to be considered.

BIL believes that integrating ESG into its investment process is a crucial element in the management of risk as well as helping to highlight opportunities. The integration framework is flexible, and adapts to changing information and understanding in an extremely fast-moving field.

It is tempting to believe that environmental and social impact and governance considerations are just ‘nice to have’. In reality, they can significantly impact companies’ financial results and their long-term value.