ESG integration unpacked

What is ESG integration it all about?

ESG integration is a strategy that combines ethical considerations related to risk and opportunities with traditional financial analysis to help you make investment decisions.

Why should you care?

ESG funds and indexes are outperforming their non-ESG counterparts. According to a study by Morningstar (2019), over the last 10 years, 58.8% of surviving sustainable funds were considered to beat their average surviving traditional peer.

When investing, capital is at risk.

What will you learn?

You’ll discover what ESG integration is, how it works and what to consider if you want to start investing.

What is ESG integration?

ESG (Environmental, Social and Corporate Governance) integration combines ethical considerations related to risk and opportunities with traditional financial analysis to help you make investment decisions.

The traditional financial analysis of a company is known as ‘fundamental analysis’, and it looks at the company’s financial statements, its competitors, the market it operates in and the economy.

ESG integration takes the fundamental analysis further by offering a more comprehensive understanding of the future opportunities and risks of a company.

ESG integration should help you incorporate ethical and social concerns into your portfolio. But bear in mind that the main objective of ESG valuation is still financial performance.

It’s possible to give ESG scores to individual companies, investment funds or entire markets.

Today, ESG investing is valued at over $20 trillion (or around a quarter of all professionally managed assets around the world). And we’re increasingly seeing ESG funds and indexes outperform their non-ESG counterparts.

How does ESG integration work?

ESG integration involves including companies and industries with high ESG scores into your portfolio. It’s a form of positive screening.

ESG rating agencies score a particular company or fund by looking at how its policies, plans and disclosure perform against ESG governance standards.

Typically, ESG rating agencies use publicly available information such as annual reports, websites, CSR reports, stock exchange filings and news sources. But each agency will have its own way of turning this information into digestible data that they can analyse and make into a rating.

Each agency will also have its own ESG rating scale. For example, one might rate on five risk categories from negligible to severe. And another may use the ‘AAA to CCC’ rating system – similar to how credit agencies rate institutions that issue bonds.

You can find a further breakdown of scores within the three main ESG components if you want more detailed insights. We’ll dive into this below.

What to consider when making your ESG integration decisions

There are three distinct components to ESG ratings. So it is possible to consider companies that score highly on just one or two of the ESG components that are important to you.

Each ESG rating agency will focus on different aspects that could make up each component, which we’ll discuss below.

As you read about each ESG component, reflect on what is important to you so you know what to consider when looking at a company’s rating.

Environmental

The environmental component relates to the company’s impact on the earth, in both positive and negative ways.

Agencies may rate policies, plans and disclosures related to some or all of the following considerations:

Social

The social component relates to how companies treat people and the contribution it makes to society. In other words, how the company treats its employees, customers and others in the supply chain.

Agencies may rate policies, plans and disclosures related to some or all of the following considerations:

Governance

The corporate governance component relates to how the company is run. So agencies will look at the quality and robustness of a company’s internal structure and practices.

Agencies may rate policies, plans and disclosures related to some or all of the below:

You’ll probably have noticed lots of overlap between the considerations with each ESG category. That’s because ESG rating agencies decide how they classify the areas of concern, which often results in 3-5 categories within each component.

Sustainability

Sustainability is when companies, industries or markets can operate within their means and remain stable in the long term. You can consider something ‘sustainable’ when economic performance is balanced with high ESG ratings.

Conclusion

The good news is that it’s never been easier for you to invest ethically using ESG integration. An increasing number of companies and funds are beginning to report on their ethical credentials. But as we’ve discussed, there is no one agreed way of rating ethical investments, so making comparisons is difficult. And unfortunately, some companies exaggerate or misrepresent their ESG and ethical credentials. This is known as ‘social washing’ or ‘greenwashing’.

Doing your research is key if you want to accurately determine whether an investment or group of investments aligns with your values. Especially when investing in a fund such as a stocks and shares ISA or pension fund.

Where to find ESG investments?

Once you’ve done your ESG research, you can pick up an investment product from:

• An online stockbroking service or platform
• A financial adviser
• A bank or building society
• A broker, or
• A fund manager

Key takeaways on ESG integration

When investing, capital is at risk. Your investments can go up or down and past results are not a guarantee of future returns.