Beyond the ESG Checklist

Where responsible investing meets risk management

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134048_to_do_list____or_not_to_do-lisResponsible investing is a method that has been used for many years to ensure that investors are meeting their ethical and moral values in their investment vehicles, and incorporating environmental, social and corporate governance concerns into their investment decisions. Approaches to responsible investing can be divided into two groups: socially responsible investing (SRI) and Environmental, Social, and Corporate Governance (ESG). SRI funds focus on avoiding certain companies through screens for undesirable businesses (alcohol, tobacco) or positive behaviour (policies for human rights, reducing environmental impacts, etc.). SRI can also include the use of best in class funds or thematic vehicles. ESG’s approach to responsible investing mandates that incorporate investment be in areas that, traditionally, have not been directly related to financial strength.

These two facets of responsible investing can be solid options for investors, as they offer a gamut of overlays and approaches to incorporate investor preferences.

When ESG first hit the scene, it was very much an offshoot of SRI that used a checklist of traits that may or may not apply to a company or investment. The methodology was used to ensure compliance with a given set of rules or values. In many circles, this is still the case. A fund may incorporate ESG by checking to ensure an investment has a policy for anti-bribery and corruption, whistle blowing or a certain standard for its suppliers. Also, ESG-type funds usually incorporate some degree of engagement with (usually an equity) investment. Often, engagement is undertaken by a third party on behalf of an asset manager, but sometimes the manager itself speaks with the investments on behalf of investors to encourage it to undertake better practices or improve in certain areas, such as health and safety. Whatever this process is called, it is still a compliance check – a means of ensuring that investments meet pre-determined requirements.

Beyond the checklist

In some circles, however, ESG has evolved from being a compliance check to an integration phase. Here, the focus is not on a prescriptive SRI-type list of must-haves or must-not-haves for companies. Instead, the emphasis is placed on the material risks that are specific to the underlying investment. This methodology is highly tailored to each investment and requires a holistic understanding of each investment’s key problem areas, as well as its related opportunity set. It can be a much more accurate indicator of an investment’s stability and longer-term outlook.

Ultimately, integration involves the assessment of an investment from a risk perspective, engaging the investment or company on how it perceives its own risks and comparing them to those identified by the investment manager. Engagement between the investment and the manager then focuses on any difference in risk perception, as well as on the group’s targets to mitigate risk going forward. Central to the conversation is the manager’s encouragement for the investment to improve its transparency on risk-related issues (as required) and its requirement that the investment publish its risk matrix on an annual basis.

In this way, the integration of ESG factors becomes a tool for managers to more effectively understand and engage with their investments on material risks and related opportunities.

Cindy Rose is head of research, Responsible Investing, Aberdeen Asset Management

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