ESG investing’ is a broad term that covers a range of activities. ESG itself is an acronym which stands for ‘environmental, social and governance’. So ESG investing is really any investment activity that takes environmental, social and governance issues into consideration.

Because it is such a broad term there is sometimes confusion about what ‘ESG investing’ means. Two managers who both claim to be practising ‘ESG investing’ may be doing quite different things and hold quite different portfolios.

ESG Investing is often presented as a spectrum starting with traditional investing, with no consideration of ESG issues at one end, and philanthropy, which focuses solely on ESG outcomes and has no consideration of financial performance, at the other. This is possibly not the best way to conceptualise ESG investing as it implies some activities are superior to others and fails to convey the way in which different activities can work together to achieve different objectives and outcomes.

This article provides some guidance around different aspects of ESG investing, with the aim of helping investors ensure the products they choose are consistent with their expectations.

ESG integration

ESG integration is the process of considering environmental, social and governance issues in investment decision making.

It should be noted that ESG integration refers to the inputs to decision making and not the outcomes. It simply means non-financial issues have been considered in assessing a security or asset. It does not necessarily mean a portfolio will comprise only sustainable, green or socially responsible companies. An investment manager who integrates ESG in their investment process may still decide to invest in a fossil fuel company or a company with human rights abuses even after allowing for the impact of ESG risks on the share price. If permitted by the fund’s investment strategy, the company is cheap enough and the expected return is significantly attractive the manager may decide to hold the stock despite its negative ESG characteristics.

Negative screening and norms-based screening

Negative screening refers to the exclusion of companies based on business activity and product involvement. Negative screens can be used to exclude companies involved in fossil fuels, alcohol, gambling, tobacco, weapons, etc.

Norms-based screening refers to the exclusion of companies based on company behaviour. The process sets a minimum standard of business practice typically based on international norms such as the UN Global Compact. Norms-based screens are typically used to exclude companies with severe human rights abuses such as forced labour or child labour in their operations or supply chains; companies that have done significant damage to the environment; and companies involved in bribery, corruption, or other criminal activity.

Positive Screening

Positive screening is the process of preferencing companies based on their exposure to positive ESG factors. Positive screens can be used as a hurdle i.e. only invest in companies that meet a specified threshold. For example, only selecting companies that are in the best x% of companies in a particular industry ranked by carbon emissions intensity. Positive screens can also be used to inform weighting decisions. An example might be increasing or decreasing a company’s weight in the portfolio, based on a composite of ESG factor scores.

Impact Investing

Impact investments are investments made with the intention to generate positive, measurable social and environmental impacts alongside a financial return. Impact investment requires both measuring the positive outcomes that result from the investment activity and reporting on those in a consistent and systematic fashion.

Sustainability Themed Investment

Sustainability-themed investments are one of the fastest growing classes of investment. Sustainability is best defined as economic activity “that meets the needs of the present without compromising the ability of future generations to meet their own needs.” Sustainability themes include climate change, waste management, healthcare, sustainable transport, green property, sustainable food production, and clean water.

Overseas regulators in a number of jurisdictions have published a ‘taxonomy’ which identifies activities that are considered ‘green’ or ‘sustainable’. In Australia, the Australian Sustainable Finance Institute is working to establish a taxonomy for the Australian market.

Activist Investing

Activist investing is the process of buying a significant minority interest in a listed company with the intention to change how the company is run. After establishing a position in a company, activist investors typically first engage with management and/or the board to effect change. What defines an activist investor is that they may quickly escalate their approach to implementing change. Actions can include open letters, media campaigns and ultimately proxy contests where they try to obtain enough votes from shareholders to elect new directors to the board.

Stewardship (Corporate Engagement and Proxy Voting)

Stewardship is a concept that is related to fiduciary duty, the responsibility an investment manager has to act in the best interest of investors. Stewardship is the process of intervention to make sure that the value of the assets is enhanced over time, or at least does not deteriorate through neglect or mismanagement.² Engagement with corporations can be on a range of issues and can be reactive to a particular issue or event or can be more long-term and thematic in nature.

Passive ESG Investing

ESG can be integrated into passive investment approaches to create transparent products that achieve objective ESG factor exposures. A passive manager can integrate ESG considerations into a fund by tracking an index that applies negative, norm-based and positive screening. Increasingly, specialist research houses are being established to provide managers and index providers with high-quality ESG data. Tailored indices which incorporate ESG metrics in their security selection and weighting methodologies are becoming increasingly sophisticated in their design as new and better data becomes available.

This article was originally produced by Greg Liddell from BetaShares. You can read the full article here.

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