ESG risk – the opportunities of active management

There are some ESG risks (environmental, social, governance) that can be removed automatically. For instance, stocks that may have high exposure to carbon taxes in the future, such as conventional energy businesses, could be filtered out early in the investment process. Likewise, sensitive sector stocks like tobacco, or companies manufacturing controversial weapons, such as cluster munitions, can be avoided to protect investors from being exposed to what could be considered unsustainable investment practices.

July 21, 2022

However, an avoidance strategy alone is not enough. A more comprehensive and active approach to ESG is needed. ESG risks are best mitigated through active management, using a firmly integrated process that combines quantitative analysis with robust bottom-up research.

How quantitative analysis is used to manage ESG risk

Using quantitative analysis to manage ESG risks may one day be automatically integrated into every investment strategy in the asset management industry. As technology improves, we are likely to see widespread adoption, and this could prove critical in this increasingly data-rich world.

Certain metrics can capture how effective companies are in having a positive impact on ESG. Integrating data into the investment process can be done in a variety of ways by helping automatically filter the investment universe.

Data can also be used to provide ratings or scores for companies, or even to provide valuable information to portfolio managers when they make active portfolio decisions.

ESG risks can also be assessed during comparable company analysis, when portfolio managers build a comparable universe of similar companies to determine whether a stock is valued correctly. Here, quantitative measures of ESG risks could be used to derive a discount rate that a portfolio manager can apply to their valuation model.

More than honey

Taking a qualitative approach to ESG risk is also important

Beyond quantitative analysis, ESG risks can also be assessed qualitatively, which is one of the most common techniques used in asset management. Portfolio managers can try to get a better understanding of ESG risks through their own fundamental research. This can often occur when they are conducting financial statement analysis with their analyst teams. For instance, this could involve searching through the notes of financial statements to gain greater insights into the operational issues that a company might face.

Portfolio managers may also analyze the supply chain of a company and the ESG risks that may threaten the sustainability of that supply chain. Additionally, portfolio managers often have personal relationships with the management teams of the companies they invest in, which gives them a unique perspective on the ESG risks that these companies face. They can even take on an active ownership role during this process to ensure that their ESG concerns are being addressed.

Actively managing ESG risks can have a positive impact

ESG investing is also about creating a positive impact. Here, the notion of “additionality” comes into play, which is when you take an action that adds value. Investments therefore need to pass the “but for” test, i.e. a positive impact could not have occurred “but for” our investment.

Impact investors are, therefore, naturally active. The logic here is that if you can add value you are more likely to have an impact and ultimately create a sustainability premium. Consequently, additionality with ESG can be easier to achieve in private markets, where investors are often actively engaged, carry out their own measurements and make use of the proxy voting process. Thematic investment also lends itself well to additionality, as themes can be associated with having a positive impact, such as edutainment, foodtech and agritech.

Using private asset due diligence techniques to manage ESG risk

Many investment teams are also adopting a due diligence approach to ESG, similar to what we see in the private equity industry. This is likely to be achieved if you focus on thematic investments and small cap stocks.

There, an extremely robust process and structured approach can be used to assess the ESG risk for each stock that a portfolio manager holds. The benefit of taking this approach is that it can remove the human bias that can sometimes creep in with a portfolio management team. It also ensures that no stone is left unturned during the stock selection process.

Furthermore, it offers a better outside view of the company being studied. Although it is important to understand the outlook that a management team provides for a business, this type of due diligence approach can also challenge and verify the claims made by a management team on how they manage ESG risk.

Using this approach to tap new opportunities

These techniques are all valuable. The more active investors are when it comes to tackling ESG risks, the greater the sustainability premium they can earn. It can also make new opportunities which may benefit from a future sustainable economy more visible.

A good example is EdTech. EdTech, or educational technology, combines computer hardware, software and education to facilitate learning. The cost of education right now is soaring in both developed and developing countries. If education is allowed to become unaffordable then the less well off in society will suffer and this will create future disparity in wealth.

Technology, however, could level the playing field by making education cheaper to access. EdTech could dramatically lower the cost of accessing education and create more social equality in the future.

ESG will become the norm

Everything that we have described is set to become standard in the asset management industry. ESG considerations will increasingly be integrated into more and more investment processes. The difference, however, will be in the approach we take. Tackling ESG should not just be viewed as a criterion and a necessity. It can also be used to find new sources of returns and opportunities in addition to having a positive impact.

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