Responsible investment is an umbrella term for the different ways people can support certain positive business practices when they invest. One of these approaches is ESG integration. It’s a way of judging a company by things other than its financial performance.
ESG integration is about seeing the whole picture when you invest.
Traditionally, a portfolio manager chooses to invest in companies based largely on their financial reports. They might look at things like earnings, profit margins and debt levels. But in recent years, there has been a growing focus on looking beyond the balance sheet. When you integrate ESG factors into the investment decision-making process, you can assess many other kinds of risks a company faces. For example, portfolio managers or investors may ask:
EnvironmentalIs the company’s business subject to increasing risks as a result of climate change?
SocialDoes the company monitor its supply chain for potential human rights violations or health and safety issues?
GovernanceWhat is the structure of executive compensation, and what measures do they have in place to combat corruption?
When you integrate ESG factors into your decision-making process, you can gain a deeper understanding of companies before you invest. This includes insight into how the company will likely perform and the value it may add to a portfolio. Research indicates that companies with strong ESG-related practices have produced:1
- lower risks
- lower cost of capital
- better operational performance
- better share price performance over the longer term.
Here are some examples of strong versus weak ESG practices:
|Company Focus||Strong ESG||Weak ESG|
|Employees||Engagement, strong culture, innovation||Lack of training, unsafe conditions, high turnover rate|
|Customers||Responsiveness, availability, dispute resolution||No returns policy, poor labelling, over-charging|
|Suppliers||Timely payment, good production planning||Reputational risk, lack of audit, lack of quality control|
|Environment||Emissions control, sustainable sourcing, renewable energy||Pollution, high cost carbon|
Source: RBC GAM June 2017
Integrating ESG does not involve negative screening or values-based judgments about a particular security or sector. These strategies are used in socially responsible investing (SRI) funds – another approach to responsible investment.
ESG, on the other hand, is not about excluding firms. For example, a fund that integrates ESG factors may continue to hold companies with high ESG risks or poor ESG practices. But the fund will be able to better identify and understand those risks and then engage with those companies to improve their ESG-related policies and practices.