ESG incorporation in listed equity – thoughts on best practice

ESG incorporation best practice

The launch of the PRI in 2006 established a globally recognised framework for responsible investment. When we developed our investment strategy less than three years later, the PRI framework remained aspirational for most market participants. Our belief was that Principle 1 (a pledge to incorporate ESG into our investment decision-making) and Principle 2 (a commitment to active ownership) were meant to be applied universally to all investment decisions, and to all owned companies. We realised that sincerely implementing such principles required building an entirely new investment process that put ESG incorporation and active ownership at the centre of the investment philosophy, process and team culture, an approach we termed “ownership investing”.

Now, over a decade after launching our strategy, evidence from our fund and other long-term ESG strategies has shown that implementing the PRI’s Principles can deliver strong long-term returns for clients while catalysing the sustainable transformation of investee businesses.

Given the ever-increasing number of PRI signatories and mounting evidence supporting the implementation of responsible investment practices, why is it then even necessary to write a blog about best practice in listed equity incorporation? Why, 15 years after the PRI’s launch, is implementation of the Principles not universal?

Simply put, the innovator’s dilemma is alive and well within the investment industry. Fully reengineering investment processes to incorporate responsible investment principles and developing sustainability-oriented cultures requires firm-wide transformational change, rather than simple adjustments to existing approaches. Furthermore, the perseverance of market short-termism creates a backdrop incompatible with the multi-year timeframe on which ESG issues become increasingly relevant and engagement dialogues can truly accelerate sustainable change within companies.

The good news is that the fund management industry has largely stopped denying the relevance of ESG issues – something that was still common just a few years ago – and is now actively seeking to develop approaches that can be genuinely considered responsible investment. It is in the hopes of accelerating this change that we share some lessons below.

The good news is that the fund management industry has largely stopped denying the relevance of ESG issues

Best practices in listed equity ESG incorporation

• Build a process for the long term: ESG risks can be relevant across all time horizons, but environmental and social indicators tend to become more important over the long term.^[1]. It is therefore vital that valuation and risk models are sufficiently long term to appropriately capture the full impact of ESG risks and opportunities and engagement needs.
• Pro-active ownership is essential and should not be outsourced: Every company is exposed to ESG risks. Since it is impossible to eliminate stakeholder risks from a portfolio, investors need to understand how risks are managed through direct conversations with the companies in which they invest. Static ESG analysis that is not contextualised and informed by interaction and engagement with a company’s management team is like driving while looking only in the rear-view mirror. Furthermore, when engagement is outsourced to isolated ESG teams, this valuable investment information is lost from the investment decision-making process.
• Size and focus matter: The average ESG equity strategy has over 250 holdings.^[2] For certain benchmark-oriented ESG equity strategies, the number of names involved is typically in the thousands. Regardless of asset class, the resources required to conduct useful ESG assessment and incorporation at scale are immense. (For context, our team of 11 covers roughly 25 stocks.) As investors, we must accept that there are limitations to the depth of ESG analysis and incorporation possible for large portfolios, and that there is a trade-off between capturing the benefits of deep ESG analysis and integration and building a portfolio with traditional diversification and capital asset pricing model risk frameworks.

What have we learnt?

• Be roughly right: As Keynes famously said, “it is better to be roughly right than precisely wrong.” When we launched our strategy, we couldn’t prove if incorporating ESG would lead to better financial results, let alone demonstrate by how much. Even today, it is not possible to extract with precision how much of our returns, or those of other successful ESG strategies, have come from ESG integration and engagement compared with other parts of the investment process. That is OK. We don’t need to agree on a number to know that factors such as culture, diversity or environmental footprint logically influence the financial performance of companies and are important drivers of risk and return.

Even today, it is not possible to extract with precision how much of our returns, or those of other successful ESG strategies, have come from ESG integration and engagement compared with other parts of the investment process. That is OK

• ESG, not E, S or G: Over the years, reporting frameworks and a preference among many investors for thematic approaches have encouraged a focus on single issues – water, deforestation, emissions – often without acknowledging the interconnectedness within and between E, S and G topics. (For a snapshot of the complexity of those relationships, see the World Economic Forum’s risk map.) Weighing up these interactions is hard and requires judgement and time. Should a technology company’s achievement of carbon neutrality outweigh its lagging labour practices? Should governance shortcomings be overlooked at a company with a breakthrough environmental technology? Without portfolios that are appropriately sized for deep analysis, ESG integration will fail to live up to its potential.

Where do we go from here?

We hope, ultimately, for the disappearance of the “ESG option” and the universal adoption of the PRI’s six Principles. Alas, we are still far from that reality today. One of our pension fund clients told us they started their recent search for a responsible equity manager with a simple filter, asking whether potential managers offer a non-ESG version of their strategies. They were amazed to see that this filter shrank their search to a handful of mostly boutique managers. Quite simply, ESG incorporation and active ownership needs to evolve from product marketing to the firm-wide cultural level, We encourage all signatories to take this step.

Looking ahead, we welcome the new generation of investors entering the workforce that have been trained from the beginning to invest in line with the principles of ESG incorporation and active ownership. We need to continue to expand the application of responsible investment by including the principles in university curricula (the British Academy is already doing important work here^[3]) and ensuring that investment mandates are structured in alignment with the long-term nature of ESG factors.

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at [email protected].