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Posted on Nov 5th, 2020

ESG Diaries: Defining the Value (and Limits) of ESG Integration

One of the more difficult parts of establishing ESG as a pillar of an investment strategy is defining it. ESG as a concept is largely something that people have a consensus on. In simple terms, it’s about sustainability and its impact on returns. But in practical terms, ESG can mean different things to different people, particularly when they overlap with other similar concepts, like socially responsible investing (SRI). Developing an investment framework around ESG ultimately led us to define it with a sharper focus.

Picking up on a theme from last month’s entry, Five Things We’ve Learned About Our ESG Approach, the first in our series. What we found when we started digging into some of the lower ESG-scoring names was both interesting and surprising. While the question of “guilty until proven innocent” and a seemingly uncomfortable probability of punishing false positives continued to weigh on our minds, we found we were almost always rewarded with some form of valuable insight when we dug deeper into a company.

Across all of our portfolios, there were very few names that had a combination of particularly meaningful ESG incidents and lax policy. In other words, we didn’t naturally own many names that would qualify as controversial or offensive. Sure, we held a couple of Canadian energy names that were easy enough to let go based on high exposure to material issues and poor management of those risks. But let’s face it, the grim fundamental picture for much of the sector made these decisions easier. Lower conviction and awareness of high ESG risk is a straight-forward combo to act on.

Beyond that, we found ourselves looking into things like REITs with insufficient energy efficiency and governance policies, and software companies that were deemed to have insufficiently considered key issues such as data security and privacy. In a world where analysis focuses on metrics such as dividend stability, balance sheet strength or growth potential, energy and privacy risks aren’t top of mind. However, they certainly can kill a company. In many cases, they represent the so-called tail risks that are low in probability but high in severity. You have to ask yourself what’s going to happen to that software company’s growth trajectory if it suffers a data breach?

These early analyses revealed an important truth about incorporating ESG in an investment strategy. It’s really not just about avoiding the offenders. It’s not about divesting from BP because it had an oil spill, or Volkswagen because it designed an emissions test-defying device for its diesel automobiles. It’s not just about excluding industries like tobacco, coal, firearms, alcohol and others which some may find offensive. It can be and to many people is, but we began to see it more as a means to identify risks around which companies were the most, or least, insulated against these kinds of crises and controversies on a forward-looking basis.

It didn’t take long for us to recognize the value of incorporating these factors into our investment frameworks and building strategies to address them, through some combination of adjusting our evaluation of risk and taking an activist approach where possible.

We’re still only at the beginning of our story here with ESG, with much more discovery and process improvement to share. What we’ve learned so far includes the notion that defining ESG is an important part of implementing it effectively. While the broad-scale benefits of ESG investing advance the cause of sustainability, at its heart, ESG investing is really about using data to make better decisions. It’s true on the societal level and at the portfolio level.

— Graeme Cooper is Vice President of Product at Purpose Investments

All data sourced from Bloomberg unless otherwise noted.

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