Ch. 8 ESG Integration and MGMT Flashcards
The endgame for ESG integration is
the combination of underlying ESG analysis to produce a more complete picture of ESG exposure and risk at the portfolio construction and management levels.
Exposure, risk, perf attribution, HL AA decision
misperceptions when applying ESG at the portfolio
level. Accordingly, this chapter will attempt to address the following questions:
- How can we characterise interest and demand for investment strategies in this area?
- What exactly do we mean by ‘ESG strategies’, and how can we understand this approach within the broader language of responsible investment?
- What are the assumptions underlying the claim for alpha generation and how can we extend them to include portfolio management and construction more generally?
often conflate the terminology of
‘responsible investment’. they rarely, if ever, compete against one another
Exclusion, esg (stewardship), impact
as per mercer report - which AC has highest and lowest level of progression on esg
high - infra
low - HF
Review Fig 8.2 +8.1
as per mercer report - which AC has highest and lowest level of strategy availability of sustanability themed strategies
High - Infr/ RE
Low - HF/FI/ RE
Review Fig 8.2 +8.1
Analysts need to justify their views in ‘a story’ or ‘investment thesis’ of
a security, this includes
▶ the intrinsic value of the security;
▶ credit analysis;
▶ the potential for a rerating or derating in valuation;
▶ potential risks;
▶ short-term and long-term catalysts; and
▶ an expectation on the security’s earnings growth and cash flow profile.
The role of portfolio managers, on the other hand, is of much broader scope. A portfolio manager constructs
and manages a portfolio through a careful process that aggregates all of the individual, underlying risks. And
while portfolio managers often form their own views-
role is to weigh securityspecific conviction against: ▶ macro- and micro-economic data; ▶ portfolio exposure; and ▶ sensitivities to potential shocks.
To this end, the ESG framework should illustrate a continuity from micro- to macro-forms of analysis, including:
▶ the organising principles and methodologies for ESG analysis;
▶ the identification and analysis of financial and non-financial (ESG) materiality at the individual security level;
▶ the approaches to build a composite picture of risks and exposure at a single portfolio level; and
▶ the representation of ESG risks and exposure that informs a mixed asset strategy which may include many
different, underlying strategies.
ESG integration can focus on risks as well as opportunities. A bias towards looking at one of these can lead to…
different return profiles at the portfolio level as the emphasis can shift from downside protection to upside
participation.
ESG integration should be considered in light of two approaches
discretionary (typically fundamental) and quantitative (screening)
investment strategies.
Broadly speaking, ESG external research and analysis can be categorised between…
academic research and
practitioner research. Each of these resources offers their own unique advantages and disadvantages for
investors.
Accedmeic vs practitioner
academic studies on an individual basis
often end up disconnected from practice and are not widely or generally applicable - good for discussion and general trends cross regional.
Practitioner
research, on the other hand, is often less rigorous than academic work, and tends to be less conservative in its
assertion to correlate ESG with investment returns, sometimes ignoring other causal factors at play.
Including:
▶ sell-side research and analysis;
▶ academic studies;
▶ investment consultant research;
▶ third-party ESG data provider research;
▶ ESG-integrated fund distribution platforms;
▶ asset owner and asset manager white papers;
▶ investor initiative research;
▶ non-governmental organisations (NGOs) research;
▶ governmental agencies and central banks; and
▶ multilateral institutions and agencies.
Portfolio managers may now treat carbon exposure on a portfolio-weighted basis (instead of company or per asset) as per the reco from TCFD. WACIM…
Weighted-average carbon intensity measures a portfolio’s exposure to carbonintensive
companies on a position-weighted carbon exposure.
Calculated as the carbon intensity (Scope 1 + 2 Emissions ÷ US$ million revenues) weighted for each position within a portfolio, this metric can be employed
by investors to tilt or overlay portfolios towards lower-carbon exposure.
organise exclusions across four basis categories:
▶ universal;
▶ conduct-related;
▶ faith-based; and
▶ idiosyncratic exclusions.
Universal exclusions represent…
exclusions supported by global norms and conventions like those
from the UN and the World Health Organization (WHO). It could be argued that controversial arms and munitions (cluster munitions and anti-personnel mines), nuclear weapons, tobacco and varying degrees of exposure to coal-based power generation or extraction all qualify as universally accepted given normative support and the growing asset owner AUM they represent.
examples on pg. 352
Conduct-related exclusions are generally…
ompany or country specific, and often not a statement against the nature of the business itself
Faith-based exclusions are specific…
to religious institutional or individual investors
Idiosyncratic exclusions are exclusions that are not…
supported by global consensus. For example, New Zealand’s pension funds are singularly bound by statutory law to exclude companies involved in the
processing of whale meat products
Exclusionary preferences are most commonly adopted and applied by…
asset owners rather than asset
managers.
investors often assume..
a best efforts approach in these cases as some issues continue to remain difficult to reconcile from a screening perspective
Another challenge is the treatment of asset classes and securities that…
outside of the traditional spectrum
of responsible investment, which has generally been focused on:
▶ listed equities;
▶ listed corporate debt; and
▶ real assets.
Quasi ESG Factors - compare highest vs lowest rated funds
Highest - size (large) - ROE - P/E - growth - Value - P/B - Quality - Momentum - Price momentum - Low volatility LOW
This is MCI (sustainalytics could be differnt)
The linkage between quality and ESG as factors stems…
from the intuition that the governance of higher ESG-rated companies drives stronger decision-making around capital allocation and shareholder returns.
what exactly is ESG?
If it can be quantified or measured, is it simply an amalgam of other established factors, like size and quality?
Linkage from ESG to Large size
ransparency bias towards large companies favours ESG because a common characteristic of high-ranking ESG companies is strong transparency and disclosure. Large companies, not surprisingly, are better equipped and staffed to address these issues, resulting in higher ESG
scores.
One of the most exciting, yet least developed, areas in ESG integration is the
degree and means to which it can
inform and shape the strategic asset allocation decision-making process and is the single most important top down decision (90% of variability of returns)
ESG is most commonly
integrated at the…
security level, complemented by more recent, increasingly sophisticated efforts to express ESG risk at a composite portfolio level.
if an allocator believes that ESG risk resides at the
underlying…
hen integrating ESG at the asset allocation level may prove a redundant exercise
he allocator believes that ESG risk (e.g. climate risk) represents a top-down risk
factor, then
integrating ESG within the asset allocation process makes sense in light of more specific climate implications
greater coverage beyond equities and corporate fixed income has now made ESG
integration at the strategic asset allocation level
more relevant
STRATEGIC ASSET ALLOCATION MODELS AND THEIR SUITABILITY TO ESG - Table 8.4
MVO - sensitive to change in assumptions - ESG may impact volatility and return assumptions
Factor allocation - could require change to baseline risk assumption - potential to build ESG as a factor
Total Port Budget - focus on risk budgeting - more scenario analysis and flex to incorporate
DAA - test assumptions over differnt time horizions
LDI - could impact inflation and alter liability assumptions
Regime switch model - capture shift in dynamics - not widley used by practitioners
Insto Investro and climate change
Table 8.5
Transition risks are…
These are the risks represented by legal, regulatory, policy, technology and market change in the transition to a low carbon economy
Inevitable Policy Response (IPR)
may take shape through the introduction of economic incentives, such as a carbon tax or the formation of national carbon markets. It may also include other measures including more stringent environmental regulations requiring greater levels of mitigation-associated capital investment for highly exposed companies.
ILLUSTRATIVE APPROACH FOR MODELLING THE INVESTMENT IMPACTS OF CLIMATE CHANGE
Table 8.6 and .7
ESG IN MANAGER SELECTION
» the existence of an ESG policy;
» affiliation with investor initiatives such as the PRI;
» accountability in the form of dedicated personnel and committee oversight;
» the manner and degree in which ESG is integrated in the investment process;
» ownership and stewardship activities; and
» client reporting capabilities.
it is important
to recognise that some asset classes and strategies face greater challenges than others
This may be because
of the lack of quality datasets in some markets, particularly for some private markets, where equities and
corporate credit have benefited the most from greater data availability and applications
Order of ESG integration in Asset class
EQ FI (EMEA - highest globally) PE RE INFa HF
FI integration
IG and EM - higher Integration
Gov and HY - lower
Table 8.11
One way for PM to manage climate risk in Corp debt
one method available to a credit
portfolio manager seeking to manage the long-term climate risk effects of an issuer is to invest in the issuer’s
shorter-dated maturing debt.
types of ESG bonds
Green - enviro
Social - essential service
Sustainable - more broad
Blue - ocean
level of correlation between ESG risk and Credit risk of Sovereign?
Modest = .62
table 8.15
ESG challenges in PE
e lack of public transparency, established reporting standards, regulatory oversight and
public market expectations around ESG and lack of require fin reporting
ESG integration methods in PE
impose exclusionary screening on any number of criteria
to restrict investment in certain sectors, either normatively or ethically defined. Hence, it is more likely that portfolio managers will apply some form of positive screening or thematic focus
within its investment charter
RE and Infa approach
▶ peer group information;
▶ overall portfolio KPI performance;
▶ aggregate environmental data in terms of usage and efficiency gains;
▶ a GRESB score that weights management, policy and disclosure;
▶ risks and opportunities, monitoring and environmental management system (EMS);
▶ environmental impact reduction targets; and
▶ data validation and assurance
Housing
carbon footprint of building (construction and maintenance) and exposure to extreme weather events
Studies demonstrating that almost 80% of alpha (returns in excess of market performance) can be attributed
to portfolio factor risk rather than stock-specific risk
would seem to support research efforts to identify and
define ESG as a standalone factor
Table 8.19
Current ESG ratings should be viewed as
more normaising risk factors, directional not an absolute
investors must
also consider the practical and operational issues when seeking to integrate ESG
More specifically, the asset class and regional exposure of a portfolio may have significant implications on the coverage and integration of the ESG screen. Equities strategies, particularly those in developed markets, with a focus on mid- to large-capitalisation companies, generally benefit from greater, more mature ESG research coverage by third-party data vendors. FI, corp is benfiting from more coverag - htough still a coverage gap in HY/Unlisted e
two ways to address coverage gap
1 - The simplest approach is to simply rescale the scoreable portion of the portfolio to 100% by proportionally
resizing each scoreable position.
2 - The second approach is to apply Bayesian inference to the coverage ratio, effectively grossing it up to 100% by
probabilistic inference.
good up to 25% coverage gaps
ESG sensitivity example
if the price of carbon on the European
Union’s Emissions Trading System (ETS) suddenly appreciates, a portfolio’s exposure to companies such as
utilities with a high dependency on coal-fired power generation will be at risk. This approach allows an investor
to run simultaneous sensitivity analyses against ESG-related shocks, like the carbon price, to test the resilience
and correlation of a portfolio
One common criticism is ESG rankings reductive approach. In other words,
its
quantitative measure does not consider softer forms of ESG, such as stewardship and engagement activities.
In fact, an investor whose portfolio focuses on long-term, stewardship opportunities in poorly rated ESG
companies in order to improve performance will likely suffer from the poor optics of these companies at the
portfolio level.
Another problem that may exist is the award of a high sustainability rating for a fund that may in fact not have
any of the essential ingredients to ESG integration – such as an ESG policy or systematic process – embedded
within its process
How should ESG be viewed in a portfolio optimisation view
ESG integration should not be seen as detrimental to the risk–return dynamic of portfolio optimisation. Rather,
it should be understood as simply another factor that potentially may enhance the risk and return profile
X would be the easiest to optimism to ESG b/c of the more common rating and transparency
Carbon - and would maintain a high overlap in holding until restricted to >55% below BM where it starts to drop dramatically
Holistic approach to ESG integration to
figure 8.25
full ESG integration strategies often take greater efforts to:
▶ evidence internal and external research resources;
▶ document how ESG is embedded, typically in a process slide;
▶ track and report on engagement activities with company management;
▶ include portfolio exposure and weightings into sustainability themes like the SDGs;
▶ provide positive impact measurements of the portfolio against metrics like resource efficiency, water and
energy consumption; and
▶ support the process with investment case studies.
Exclusionary screening is the …
is the oldest and simplest approach within responsible
investment. Emerging under the moniker of socially responsible investment (SRI), the original objective was
to impose a set of values or preferences to screen through an ethical or normative framework a portfolio’s
exposure to specific sectors.
May have impact on TE, active Share and factor exposure
Positive alignment or best-in-class represents to some degree the …
nverse of exclusionary screening. It
employs a given ESG rating methodology to identify companies with better ESG performance relative to its
industry peers.
The diversity of ESG ratings methodologies and lack of ratings convergence are a key challenge these strategies
face.
a common criticism for best-in-class ESG strategies is that ...
their focus yields diminishing ESG returns with little opportunity to
demonstrate incremental gains via active ownership efforts.
Active ownership may leverage direct engagement between investor and company management
▶ encourage greater disclosure;
▶ improve transparency; and
▶ increase stronger awareness around ESG issues
Impact investing describes strategies where the production
of a measurable positive social or environment
impact is the primary investment objective. Impact investors represent diverse interests and expectations
for financial returns.
Impact reporting should include
▶ relevant product and services (revenue) exposure;
▶ regions, notably developing economies which the SDGs were originally designed for;
▶ sectors such as water utilities, renewable energy and healthcare;
▶ the relevance of supply chains;
▶ the additionality benefits of one or more of the SDGs, which may manifest in KPIs, such as job formation,
renewable energy power generation and potable water production; and
▶ additional sustainable forms of agriculture and aquaculture
table 8.27 examples report
3 examples of insto investors using passive for ESG goals
California State Teachers’ Retirement System (CalSTRS) employs indices to meet ESG objectives and achieve
lower cost and efficiency for its beneficiaries, which includes investment in the MSCI ACWI Low-Carbon Target
Index.84
Taiwan’s Bureau of Labour Funds (BLF) pension scheme selected the FTSE4Good TIP Taiwan ESG Index for a
five-year passive mandate.85
Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, is well known for its
use of ESG-dedicated indices. This follows the creation of the Nikkei 400, which linked corporate governance
reforms under Prime Minister, Shinzo Abe, to improved capital efficiency metrics like return on equity (ROE).
GPIF’s indices include global and domestic environmental strategies, which overweight carbon-efficient
companies as well as a socially-oriented index, the MSCI Japan Empowering Women Index.
Table 8.14 illustrates the diversity of approaches and sources that GPIF has employed within its passive
investment strategy. Table 8.14
The wider availability of ESG data and greater investor interest in responsible investment has also led to the
development of new, alternative approaches within passive investing. Single-factor ESG strategies
▶ ESG;
▶ climate and environmental markets;
▶ ethical and normative exclusions; and
▶ single ESG themes, like diversity as measured by female board representation.
TYPICAL ESG INDEX CONSTRUCTION - table 8.30
parent
method
governance
underpinned by ESG data
screening impact on TE by sectors
FF impact income and value highest
sinn has impact on growth
Table 8.31
passive strategy engagement
While passive investment strategies are capable
of proxy voting, the nature of their strategies innately limits their ability to engage with portfolio companies
unless coordinated by an established stewardship team. One implication of this is that passive investing
may translate into shallower forms of stewardship activities
academic research examining the performance considerations
and trade-offs of ESG integration into passive portfolio management remains
relatively scarce (low trade off)
