- This page provides a quick summary of how an investor can manage environmental, social and governance (ESG) issues in listed equity portfolios.
- It outlines options for how to include ESG issues when building an equity portfolio and when working with companies on how they manage ESG issues.
- For more information on anything on this page, or responsible investment more broadly please get in touch
The PRI defines responsible investment as a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership.
It complements traditional financial analysis and portfolio construction techniques.
This page will take you through the following approaches to managing ESG issues in listed equities:
Considering ESG issues when building a portfolio (ESG incorporation)
ESG issues can be incorporated into listed equity investment strategies using three approaches: integration, screening and thematic. Investors select between, or combine, these approaches based on their desired outcomes. This may be to enhance their risk-return profile, avoid specific companies or sectors, or drive capital towards particular environmental and/or social goals.
The actions investors take to include ESG issues when building a portfolio are covered by Principle 1 of the six Principles for Responsible Investment: “We will incorporate ESG issues into investment analysis and decision-making processes.”
Comparing key characteristics of ESG incorporation approaches in listed equity
This table gives a broad overview of some of the differences between the major types of ESG incorporation. It is not a detailed or exhaustive classification
Working across the active-to-passive spectrum
While ESG incorporation is often associated with active strategies, passive strategies can also take ESG issues into account.
ESG incorporation in listed equity across the active-to-passive spectrum
Integration: adding factors to financial analysis
Material ESG factors are identified and assessed alongside traditional financial factors when forming an investment decision about a specific company or the overall portfolio structure, to lower risk and/or enhance returns. Investors apply a range of techniques to identify risks and opportunities that might remain undiscovered without the analysis of specific ESG data and broad ESG trends.
Integration typically has three steps:
- Security research: Identifying material ESG issues that impact equity valuations (or provide topics for engagement).
- Security valuation: Integrating the material ESG issues into financial analysis and valuation, e.g. by making adjustments to required rates of return, valuation multiples, forecasted earnings, cash flows and balance sheet strength.
- Portfolio management: Including the ESG analysis in decisions about portfolio construction, e.g. through sector weightings.
Screening: Filtering the investable universe
Screening uses a set of filters to determine which companies, sectors or activities are eligible or ineligible to be included in a portfolio based on an investor’s preferences, values and ethics. For example, a screen might be used to exclude the highest carbon emitters from a portfolio, or to target only the lowest emitters. ESG scores can be obtained from specialist ESG service providers, or by creating a proprietary scoring methodology.
Thematic: allocating capital towards enviromental or social outcomes
Thematic investing identifies and allocates capital to themes or assets related to certain environmental or social outcomes, such as clean energy, energy efficiency or sustainable agriculture.
Impact investing is a subset of thematic investing that aims to ensure that investments lead to additionality of impact – meaning a social or environmental outcome would not have been achieved without that particular investment. It also requires adequate measuring and monitoring of the investment’s impact on environmental or social outcomes.
Improving investees’ ESG performance (Active Ownership or Stewardship)
The actions investors take to encourage the companies they are already invested in to improve their ESG risk management or develop more sustainable business practices is covered by Principle 2 of the six Principles for Responsible Investment: “We will be active owners and incorporate ESG issues into our ownership policies and practices.”
Investors can use their position (and legal rights) as partial owners of companies to influence a) what activities those companies engage in, and b) how they behave and operate. Through this process – known as active ownership or stewardship – active or passive investors can encourage companies to:
- better manage material ESG issues to minimise risks and maximise performance;
- increase the quality of information they disclose on ESG issues, allowing investors to make more informed decisions;
- improve corporate practices to promote financial or non-financial objectives.
An initial step is to publish a policy outlining the investor’s overall active ownership approach, the priority issues, plans for reporting and views on escalation. This is particularly important if engagement is outsourced.
Investors should consider not only ESG risks and opportunities that are relevant to individual companies, but also long-term risks that affect the whole portfolio, such as climate change.
Engagement, voting and investment decisions feed into each other. Research that is carried out for engagement can also be used to determine voting decisions. Alongside voting, investors can file shareholder resolutions to escalate an issue if engagement is unsuccessful. As a last resort, an investor may choose to divest or take legal action against the company or its board.
Interaction between engagement, voting and investment decision
Engagement: Working with companies
Engagement sees investors working with investee companies to improve how they are managing or disclosing ESG performance. It can be a proactive attempt to address something the investor’s own research and analysis has highlighted, or a reactive move, such as in response to a controversial event.
Investors can engage individually, in collaboration with other investors (including across asset classes), or through an outsourced engagement service provider. Engagement typically involves private meetings or letters between investors and companies, but can also involve dialogue at the company AGM, or in other shareholder meetings such as during earnings calls or roadshows.
Academic research commissioned by the PRI1 shows that successful engagement can contribute to better corporate financial performance, improved shareholder returns and strengthened relationships between investors and companies.
Good engagement requires identifying relevant ESG issues, choosing a company or group of companies to engage, setting objectives, tracking results and feeding those results back into investment decision making. Persistence, consistency and listening are key.
If initial engagement efforts are unsuccessful, investors can consider escalation strategies such as collaborating with other investors, contacting the board, issuing a public statement, voting against directors, filing a shareholder resolution, seeking legal remedies, reducing exposure or divesting. Divestment is typically seen as a last resort, and passive investors will not be able to reduce exposure or divest unless they exit the index entirely, or adjust weightings if using a tailored index.
Voting: Holding management to account
Voting practices have long been a central part of how investors can express concerns over governance issues such as board pay and director appointments, but resolutions proposed by shareholders increasingly relate to social and environmental issues as well.
Voting involves research, casting votes and communicating with investee companies before and after the AGM. It is also regarded as good practice to explain to the company the reasons for any votes against management or voting abstentions. Public reporting of voting decisions is also increasingly common.
While outsourcing voting activities to proxy advisors is essential for investors that hold thousands of companies, responsible investors dedicate time and resources towards ultimately making their own informed decisions, rather than automatically acting on their advisor’s recommendations.
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