This report develops a new typology for classifying the approaches that institutional investors take to integrate environmental, social and governance (ESG) factors into their investment process. Recent years have seen a surge of investor interest in integrating ESG information into financial analysis and investment decision-making. The investment community’s growing use of ESG information has raised the importance of understanding how investors are addressing ESG factors in their investment processes and created the need for an overarching framework to organise the increasingly diverse approaches to ESG integration that are being deployed in the market. The aim of this report is to create a framework that stakeholders can use to classify approaches to ESG integration. The typology is informed by an analysis of the practices of 70 institutional investors and includes desk-based research and semi-structured interviews with 35 investor representatives.

Approaches to ESG integration are classified along three dimensions: management, research and application. Each dimension features two key differentiators that capture, at a detailed level, the critical elements of different approaches to ESG integration.

1. Management (who is integrating ESG)
   – Degree of centralisation of ESG functions
   – Process to ensure ESG integration
2. Research (what is being integrated)
   – Scope of research
   – The degree of modification of ESG inputs
3. Application (how the integration is taking place)
   – Top-down techniques
   – Bottom-up techniques

In addition to clarifying the essential characteristics of different approaches to ESG integration, the analysis identifies prevailing types of ESG integration. Six prevailing types of ESG integration: 1) the Believer, 2) the Cautionary, 3) the Statistician, 4) the Discretionary, 5) the Transition-Focused, and 6) the Fundamentalist.

The Believer executes ESG integration in a manner that is clearly structured and consistent throughout an organisation. Integral to this approach is a top-down application of general (i.e. not based on security-specific fundamental analysis) assumptions about how certain ESG factors may affect value.

The Cautionary approach seeks to ensure that investment teams consider ESG factors in order to improve risk management, focusing on company-specific research rather than broad ESG trends.

The Statistician uses statistical analysis to identify correlations between historical ESG performance and historical financial performance with the aim of identifying material factors that are likely to generate alpha. This analysis is built into models that are applied to passive or smart beta strategies.

The Discretionary approach considers ESG factors on an optional basis as a supplement to traditional financial analysis, usually with a focus on idiosyncratic risk management.

The Transition-Focused approach regards ESG factors as central research inputs, and concentrates to a significant degree on risks and opportunities associated with broad ESG-related economic shifts, ESG thematics and sustainability challenges.

The Fundamentalist aims to integrate ESG factors thoroughly into bottom-up analysis and decision-making by considering company-specific ESG factors as well as macro ESG trends that may affect a company’s performance over short- and long-term time horizons.

The report concludes by offering five high-level observations about the general state of ESG integration, focusing on industry challenges and opportunities.

1. ESG-based screening, a technique employed by many investors, is classified as ESG integration only if carried out based on an investment case, rather than for the purposes of values alignment or reputational risk management (for the asset owner or asset manager).
2. The typology does not capture the full complexity of ESG approaches in the market. The role of active ownership is not considered and portfolio mechanics such as asset allocation is largely excluded.
3. To understand the structure and role of ESG staff within an organisation, the analysis considered whether a firm employs ESG specialists and, if so, whether they are embedded in an investment team or operate independently.
4. A centralised management approach involves organisational initiatives and processes carried out by dedicated ESG personnel or teams, whereas a decentralised approach requires portfolio managers and analysts in portfolio management teams to be responsible for carrying out ESG-related functions.
5. For motivating ESG integration, a centralised approach emphasises the subject matter expertise of ESG specialists, while those taking a decentralised approach typically stress the (investment) decision-making authority of portfolio managers and analysts.
6. Management processes to ensure ESG integration come in several forms. While mandatory ESG reporting may apply to all investment decisions, some firms choose to apply a more focused approach to particular industries, or to companies that fail to meet specified ESG risk thresholds.
   
7. An investment firm’s corporate culture plays a significant role in determining the way in which ESG responsibilities are structured and whether ESG inputs are considered to be important.
8. Some market observations from the research included; portfolio managers do not always use the ESG research they have access to; it is difficult to determine the actual state of ESG integration; using ESG in bottom-up, security-specific investment models is particularly challenging; and investors have concerns with external research providers.
9. It is important to revise this analysis to see if the differentiating features of ESG integration shift over time.