How firms take environmental, social and company governance into consideration
Aluxum | E + | Getty Images
Sustainable investing takes environmental, social and governance aspects into account.
But how exactly do these factors fit into the analysis process and how do they create added value? CNBC consulted with several experts to find out.
In general terms: “We look at a company’s business models and their geographic location and assess the ESG factors they are exposed to,” said Diederik Timmer, Executive Vice President at Sustainalytics, who provides ESG-related ratings and research on companies.
ESG factors vary by company and industry.
For example, a financial institution may face concerns such as financial inclusion (access to those in need), employee satisfaction, and business ethics, he said. To see how well the company deals with these factors, Sustainalytics will closely examine the company’s management systems and policies, reporting of results, and negative press.
More from impact investing:
Here’s why 401 (k) plans are lagging behind in green investment options
The Biden administration could affect the investment in Game Changer
How to capitalize on investment opportunities for climate change
It may seem strange at first to apply measurable values to societal problems, but it is possible. Measurable social metrics for a company include employee turnover, percent diversity, and wage ratios, said Conor Platt, founder and CEO of Confluence Analytics, which aggregates ESG data and creates predictive performance metrics for individual companies and exchange-traded funds . These factors are then ranked against peers in their specific sector or industry.
“Every time you own a stock, you own thousands of data points,” said Platt. “And for investors, ESG metrics are the best way to assess intangible asset risk.”
In recent years, an increasing number of bond analysts have been paying attention to ESG factors, said Judy Wesalo Temel, senior vice president, director of credit research at asset manager Fiera Capital. Municipal credit rating agencies have also been focusing more on these factors, she added.
“Investors are always looking at bond proceeds, but they also want to know exactly where their money is going and ‘Can you find the data on the overall long-term impact of the bond?'” She said.
ESG analysis captures issues that standard credit analysis typically overlooks, such as climate impact and corporate governance concerns (e.g. timeliness of issuer financial disclosure and transparency of budgetary processes), Temel said. ESG-related insights, in turn, shed new light on municipal bonds.
“People buy [them] To uphold the principle, tax exemption and safety, “she added.” In addition, Muni bonds are the original impact investment instruments.
“They build schools, roads, hospitals – anything that can improve the human condition.”
The challenges of the ESG
Certified financial planner Marcio Silveira, a financial advisor at Toler Financial in Silver Spring, Maryland, took a deeper look at the methodology of a major ESG rating firm and found several inconsistencies:
- A lot of subjectivity is used to decide which ESG factors to focus on.
- There is still no consensus on which topics are relevant.
- Reporting on ESG issues is inconsistent.
- A lower rating doesn’t always capture a fund manager’s potential for shareholder activism to create change.
There are inherent complexities involved in working with ESG data, according to Platt.
“The data market is fragmented. When you buy an ESG rating, you don’t get a consensus view, you get a proprietary view,” he said. “You’d have to buy several to be sure of the ratings.
The world could ultimately reward companies for better behavior and better management of these important risks.
Financial advisor at Toler Financial
“The harder problem is what to do with this data,” added Platt. “Not all ESG factors contribute to stock performance.”
In addition, individual asset managers have their own processes. “Adding new elements to the mix is both scary and cumbersome,” said Platt.
Just as asset managers need to be informed about ESG factors, advisor clients need to be informed too. According to Jay Lipman, co-founder and president of Ethic, a technology platform and sustainable asset manager, adding value goes beyond financial returns. His company offers training materials for both consultants and their clients, illustrating 19 ESG categories, each with sub-categories (see graphic of such a category).
This training gives consultants the opportunity to deepen their commitment to their clients in order to minimize the wear and tear and generate new business, be it through sustainably focused clients or new talent, Lipman said.
“Advisors are the channel that uses investors’ emotional connection with their money,” he said. “Customers not only see that their money is well spent, they also feel more empowered.
“Customer reactions to the toughened safety glass are visceral. It’s an emotional conversation.”
Lipman calls this “full information investing”.
“It’s about framing – we’re building this portfolio for the rest of your life,” he added.
For its part, Silveira sees a macroeconomic advantage in integrating ESG factors into the analysis process.
“We are excited about ESG that when the market integrates and understands the mechanics of these types of risk, it will result in higher valuations and prices for the companies with the lowest ESG risk,” he said.
“The world could ultimately reward companies for better behavior and better management of these important risks,” said Silveira. “And ultimately, higher valuations translate into a lower cost of capital.”