The ESG integration framework

The ESG Integration Framework provides a reference for practitioners to analyse their peer’s environmental, social and governance (ESG) integration techniques. ESG integration provides practitioners with additional views on an investment’s inherent risks and opportunities, representing a useful complement to practitioners’ current investment processes and practices.

Qualitative analysis versus quantitative analysis

ESG issues help investors arrive at estimates of fair stock value. ESG integration is commonly implemented using qualitative analysis, but practitioners are increasingly quantifying and integrating ESG issues into company/issuer valuations.

Equity investing versus fixed income investing

ESG integration in equity analysis is more developed than in fixed-income analysis. However, ESG issues are increasingly relevant to fixed-income investing, particularly considering the long-term horizons for many issuers and the relevance of ESG risks and opportunities.

The inner circle – qualitative analysis

The Inner Circle provides an overview of qualitative analysis techniques that practitioners use to incorporate ESG issues into their investment processes. These include engaging with company management and board, collecting information through company questionnaires, and using third-party research providers. Third-party research providers can provide sector and/or company-specific analysis that may not be easily available to investors.

The middle circle – security level

The Middle Circle illustrates the security selection phase of ESG integration. Practitioners assess ESG risk by considering how material each factor is to a security’s performance and by selecting sources for quantitative or qualitative ESG data.

The outer circle – portfolio level

The Outer Circle demonstrates the portfolio selection phase of ESG integration. Practitioners select the ESG benchmark to which they compare their portfolio, adjust the portfolio’s risk and return profiles, and establish buy/sell policies.

Equity case studies

The Equity Case Studies table provides examples of ESG issues relevant to equity analysis, the associated risks and opportunities, and the impact on revenues and margins.

ESG integration in action: Apollo hospitals

Apollo Hospitals is an Indian company with a strong governance structure and a well-regarded management team. The company’s management team set achievable ESG-related targets and provides a strong example of ESG integration in emerging markets. Their recommendation is to invest in companies that set achievable ESG-related targets.

Development of a broader ESG strategy for godrej group: Arisaig

Arisaig Partners developed a broader ESG strategy for the Godrej Group, which considers the ESG-related risks and opportunities for businesses in emerging markets. The Godrej Group adopted and implemented this strategy in response to changing business conditions, and it provides a strong example of incorporating ESG criteria into a firm’s business model.

A framework to incorporate sustainability “sustainably” for quantitative managers

The framework recommends a ‘Top-Down’ approach for integrating sustainability-related factors into quantitative strategies. It is based on Monte Carlo simulations that adjust bottom-up consensus earnings estimates with material ESG information to arrive at adjusted estimates of fair value.

An ESG integration process for corporate bonds

Breckinridge Capital focuses on researching ESG issues that are financially material to a specific issuer, rather than rating issuers according to relative ESG performance. Their process helps minimise weaknesses that are inherent in ESG ratings, such as the lack of standardisation and the use of different metrics by different providers.

Conclusion

Practitioners can use ESG data in their analysis, but ESG integration remains in its relative infancy. Fixed-income investors should consider the long-term horizons for many issuers and the relevance of ESG risks and opportunities. The implementation methods of ESG integration vary significantly from one firm to another.