ESG integration in sell-side equities research

Sell-side brokers integrate ESG information with traditional financial information – by leveraging their financial information systems, their access to company management, and the expertise of mainstream, sector-focused investment analysts – to improve research.

Sell-side brokers started integrating ESG factors into research over 15 years ago. They were driven to publish ESG-integrated research by investment managers that wanted new investment opportunities, demanding studies on the financial implications of broad ESG themes on the economy, industries and companies, and on the impact of specific ESG issues on stocks in their portfolio(s) and investment universe.

To meet these demands, sell-side brokers have produced various types of research that cover ESG themes and issues. How deeply any of these approaches are integrated into investment recommendations by the sell-side analysts varies: sell-side analysts can generate ideas and investment themes for investment managers to integrate, or they can directly integrate ESG factors into fair values and investment recommendations (e.g. buy/hold/sell) themselves.

Sell-side analysts will integrate ESG factors, alongside other financial factors, into their forecasted company financials and/or models (commonly the discounted cash flow model). (See ESG integration techniques for the different integration techniques used).

Integration in the financial forecasting phase

ESG considerations can affect economic analysis, industry analysis and company analysis. The results are applied to a company’s forecasted financials (e.g. revenues, costs, asset, liabilities, tax rates, etc) via the income statement, balance sheet and cash flow statement.

Economic analysis

Sell-side analysts assess the impact of ESG factors on the economy to adjust forecasted economic growth rates, and apply these to a company’s forecasted financials.

Political governance has long been an integral part of economists’ forecasts, as have many of the other ESGrelated trends that form the basis of responsible investment analysis, such as the aging population, biotechnology and emerging market growth. However, the idea of explicitly investigating the impact of individual ESG factors on the economic outlook of a country or region has only recently started to become popular (largely as a result of fixed income investors’ interest in differentiating sovereign bonds on the basis of their issuer’s approach to these issues).

Industry and company analysis

Integrating ESG factors within industry and company analysis highlights the impact of sector-specific factors on industries and the competitive positioning of companies within them.

Value driver adjustment

This type of integrated research identifies one or more ESG factors material to a particular sector, and integrates it/ them into valuations and investment recommendations of companies across that sector.

Theme exposure

One of the most common forms of ESG-integrated research explores which industries are associated with an ESG theme, and in turn which companies within it. Typically, the research can be split into five stages.

Identify trends: Find out the size and segment of the market that is exposed to the ESG theme and forecast the market’s growth potential.
Identify investable entry points: Identify how (if at all) it is possible to gain exposure to the market via equity investment.
Identify stocks: Identify the individual stocks that are exposed to the theme.
Analyse stock exposure: Quantify how exposed a company is to the theme. The best stock exposure analysis details the precise revenue exposure of companies.
Stock valuation and investment recommendation: Connect the ESG theme, the market trend, the entry points and the exposure of individual companies with the stock valuation of those companies, delivering an ESG-driven investment recommendation.

Integrated performance benchmarking

When the ESG issue is clearly significant in shaping the competitive dynamics within an industry, but it is less clear how this can be translated to the company’s financials, analysts often apply a score. They assess companies based on ESG and other financial factors, and then allocate a score that reflects their absolute performance and performance relative to industry peers.

The score guides the buy-side investor on which stocks have performed well and badly based on the relevant factors, and hence could affect investment decisions. These scores differ from ESG ratings by ESG research providers, as they explicitly consider the financial impact of ESG issues.

Subject-specific benchmarking

This indicates potential disruptions to competitive positioning within individual sectors. The indicators in this technique are sector-specific and must be deeply rooted in the competitive dynamics of the sector if they are to be valuable.

Integration in the company valuation model phase

This is the stage in the valuation process at which analysts adjust their models and calculate a fair value/target price for a company.

Aerospace & Defence: is ESG ready for lift-off? (Oddo Securities, December 2011)

One example of sell-side research that applies integration techniques at the valuation phase is Oddo Securities’ development of a Weighted Average Cost of All Capital (WACAC). Oddo argues that emerging environmental and social themes make it necessary to take a broader perspective of companies’ assets and liabilities and to reflect this in the cost of capital that is used within a discounted cash flow (DCF) valuation.

This approach adds Natural Capital and Human Capital to the cost of equity and the cost of debt such that the weighted average cost of all capital is calculated as follows:

Oddo further argues that “the cost of shareholders’ equity also needs to be re-examined using the following formula:

Adjusted Cost of Equity = Rf+ ßsE[Rs - Rf] + E(Rc)

where Rf remains the traditional risk-free cost. In contrast, RS corresponds to the profitability required for the sector by investors in light of specific risks. The environmental and social risks are evaluated, a Sustainability Intensity and Intellectual Capital Intensity assigned and combined (on a weighted basis) to give an ESG Intensity score which can then be applied to the valuation of stocks.

Incentivising the sell-side to produce ESG-integrated research

As well as the strength of the underlying investment case for integrating ESG factors’ influences on economies, industries and stocks, the sell-side’s production of ESGintegrated research can be motivated by requests and commission-based incentives from the buy-side.

Our research identified the following bases being used for determining the amount of commission to be allocated to ESG-integrated research:

Brokerage commission percentage

Allocating a percentage of overall commission, to incentivise further ESG-integrated research.

Fund-specific commission percentage

Allocating a percentage of the commission generated from specialist responsible investment funds f trading.

Voting for brokers

The investment team, including ESG specialists and managers, can vote on which sell-side broker(s) provides the best ESG-integrated research.

Scoring brokers

Brokers that are rated higher than a base score on their ESG-integrated research and offering are considered eligible for selection. Those rated below a base score have one year to exceed the base score, after which they can be no longer be selected.

Background on sell-side commission

Traditionally, buy-side investors have paid for sell-side research by directing their stock-trading activity towards those brokers that provide them with the best research.

Typically managers either tag individual trades (e.g. “I’m doing this trade via ABC Capital Markets because of the great research on income inequality written by Jenny Jones”) or use a broker vote process whereby analysts and managers are invited to consider which sell-side analysts and salespeople have delivered the best research and to use this to set commission allocation weightings for the period (typically quarter) ahead.

Importantly, there is no fixed price at the point that the research is delivered: it is purely at the discretion of the investment manager and dependent on the volume of trading in the period ahead.