ESG adoption is now widespread among investment managers. Ninety percent of the 1,130 global investors surveyed in our latest ESG Global Study* have integrated ESG into their investment approach. Rising client demand, the desire to make an impact, new regulations and greater recognition of the potential financial consequences of ESG considerations have been cited by previous survey respondents as the main drivers for continued adoption.

The most widely used approach to-date, as measured by total AUM, is ESG integration, whereby investment professionals seek to improve investment research by evaluating environmental-, social- and governance-related risks and opportunities that could have a material impact on investment results. ESG integration is widely considered to be an enhancement to analysis and to focus on ESG considerations that are material to the investment case.

Despite its popularity, ESG integration is not defined in any singular way by an international standard, common reporting framework or regulatory regime.

Until global standards emerge, implementation is likely to remain varied across managers. For some managers, ESG integration may be used in combination with other ESG approaches, such as negative or positive screening. A particular investment manager’s approach typically aligns with its own investment philosophy and with the clients and geographies it serves.

Focusing on the bigger picture: Long-term value

Effective ESG integration can deepen understanding of individual companies and other issuers by introducing new sources of insight for investment analysis. As such, it is increasingly considered an important evolution in the investment process for active managers. For example, product innovation in paper and packaging may help address consumer concerns and emerging regulations on single-use plastics. At the same time, customers are demanding more environmentally conscious products — a material “E” opportunity. Conversely, a lack of oversight in a multinational chemical manufacturer’s supply chain may result in improper labour or materials sourcing and disposal, thus opening the firm up to significant reputational risk and potential for legal action — a material “S” risk.

The analysis of material ESG issues has helped Capitals Express Investments investment professionals identify potential opportunities and areas of risk that the market may misprice — fueling differentiated investment insights.

With that in mind, here are three ways ESG integration has helped enhance our investment approach:

1. Generating new investment ideas

Identifying a compelling investment opportunity or an area of mispriced value is one of the most challenging aspects of investing. Megatrends, geopolitical and economic developments, new regulation and legislation, and emerging technologies and innovations all can create potential opportunities or risks for a company, issuer or, in some cases, an entire sector. A Japanese multinational offers a recent example of how investment analysis and ESG megatrends came together. During the initial stages of research, one of Capitals Express Investments’s investment analysts identified that environmentally conscious heating and cooling products account for up to 70% of the firm’s total sales.

Rising global temperatures, urbanization, population growth and higher incomes should increase demand for cooling systems. The International Energy Authority has estimated that demand for space cooling in 2050 could be triple what it was in 2018, suggesting the firm’s product mix is well-positioned for these conditions. However, cooling systems account for 10% of global electricity usage and are estimated to contribute to 4% of annual greenhouse gas emissions globally,^‡ underscoring the importance of energy-efficient product solutions.

As of 2021, 99% of the air conditioning units that the company sold either consumed 30% less electricity than a conventional air conditioner or had at least 66% less global warming potential than conventional refrigerants.

The investment analyst’s research highlights that, amid the structural rise in demand for energy-conserving products, the company could claim heating, ventilation and air conditioning (HVAC) market share. This emerging “E” innovation is just one instance where ESG integration has helped our investment analysts identify and better contextualize a compelling longer-term opportunity.

2. Enhancing investment research and analysis

Understanding the long-term impact an ESG issue may have on an investment is complex. The ways in which a company interacts with its customers, suppliers, regulators — and even its own employees — can all affect its results and prospects. The analysis of ESG issues enhances the fundamental research that is core to our investment approach, The Capital System^TM. It helps our investment professionals deepen and refine their understanding of the companies and issuers in which we invest.

For example, our investment frameworks highlight human capital management and board diversity as material ESG issues for many sectors, and our health care ESG analyst recently identified potential concerns in regard to these two areas at a European medical device company. Employee sentiment at the firm, as measured by alternative data provider Glassdoor, was below average for the sector — a potential risk for attracting and retaining talent. In addition, the board of directors lacked gender diversity, a material risk in our analyst’s view due to the lack of diversity of perspectives and potential to impact board effectiveness.

These findings prompted a discussion between our ESG analysts, an equity portfolio manager and members of the company’s board. Specifically, we wanted to understand the reasons behind the decline in employee sentiment and also gain insight into plans to expand the board of directors.

During this engagement, the company explained that the primary drivers for the decline in employee sentiment were related to a recent restructuring of the sales-force and leadership roles, as well as a decline in the stock price impacting employee ownership. Our ESG analyst and portfolio manager also learned that, in response, the company implemented initiatives to help mitigate turnover, including enhancing career development opportunities, share grants, review of salaries and internal employee sentiment surveys. As of March 2023, the company had also increased the gender diversity of the board of directors to 30% female representation.

In this way, ESG integration helped our team analyze and better understand key areas of concern related to the impacts of human capital management and board diversity on corporate performance. In addition, the company was receptive to our team’s feedback to increase disclosure on these topics, helping to enhance transparency for shareholders in the future.

ESG integration can also lead to the reassessment of an investment thesis. For example, as part of our sovereign monitoring process, a South American issuer was flagged for further research and review. The primary drivers of the flag were related to deteriorating underlying third-party governance and social metrics, as measured by the World Bank’s Worldwide Governance Indicators and the United Nations Human Development Index, respectively. The flags indicated a decline in the country’s control of corruption and a decline in life expectancy at birth.

Prompted by the flag, one of our fixed income investment analysts conducted a deeper analysis into these issues. Anti-corruption efforts for this issuer had been deteriorating for many years and our analyst determined that the weaker anti-corruption controls could further increase geopolitical risk. The analyst also believes it could hinder the sovereign’s future ability to secure funding from the International Monetary Fund (IMF) or multilateral institutions (which are often the lenders of last resort). Meanwhile, the analyst concluded that an observed fall in life expectancy was mostly due to the COVID-19 pandemic and that inadequately funded public services would not support a meaningful rebound.

Consequently, the analyst had a more cautious outlook — viewing limited exposure to the country as prudent. In their view, bond pricing did not fully compensate investors for an overall deterioration in the country’s credit risk, partly due to heightened concerns around the country’s control of corruption. Translating third-party ESG data into actionable insights is another way in which ESG integration can add value.

3. Support deeper engagement with issuers

Engaging with companies and issuers is a crucial aspect of understanding management teams and their strategies, as well as assessing investment risks. Engagement topics on material ESG-related risks and opportunities can run the gamut — from employee morale (as noted earlier) to the nuances of environmental regulatory risk. Better understanding of these issues helps our investment professionals make informed decisions and can help encourage improved disclosure on these topics in the future.

In some industries, engagements on certain topics can arise more frequently than in others, such as executive compensation in information technology and other high-growth areas of the economy.

Recently, one of our investment analysts had grown concerned by compensation structures at a U.S. human resources software and services company. Over an extended period, the analyst discussed compensation policies at the firm and how they could align better with shareholder interests.

So-called evergreen provisions, which allow for the automatic increase of shares available for issuance in an equity plan each year without the need for shareholder approval, had become a particular concern. The firm’s evergreen provision allowed it to increase its share reserve by up to 3% of shares outstanding per year over the 10-year life of the equity plan — a clear dilution risk that could diminish value for long-term equity investors.

Following further research and analysis, our investment analyst met with the company to share their views on prevailing industry standards relating to the structure of incentive plans and to discuss the dilution risk that the evergreen provision creates for long-term investors.

The board approved a revision to the equity incentive plan that removed the evergreen provision. Furthermore, the firm now recognizes that prevailing industry practice is to present an annual general meeting ballot item requesting a specific allotment of shares to use in their equity plan every few years. This approach allows shareholders an ongoing opportunity to assess the potential for dilution. Initial research and analysis on this “G” issue, therefore, informed our investment analyst’s engagement with the company and set the stage for productive discussions on improving alignment with shareholder interests.

The bottom line: ESG integration is about value, not values

As evidenced by these examples, ESG integration, in our view, helps surface issues alongside traditional financial analysis that inform a long-term investment outlook.

Similar to other considerations when investing, ESG integration is about incorporating relevant data and insights that help assess, price and decide. Considered alone, each individual input into an investment process may have limited value. In combination, however, ESG integration can complement traditional financial analysis and help complete the “puzzle” of investing.