Paolo Sardi, one of the founders of investment specialist ECPI, takes a detailed look at investment suitability covering the key issues and challenges for planners and clients looking for investments that meet sustainability guidelines.

ESG (Environmental, Social and Coporate Governance) research consists of the integration of intangible value and non-traditional risk factors with mainstream quantitative financial analysis, in order to provide investors with a comprehensive, risk-adjusted picture of the analysis.

Investors across all asset classes (from fixed income and equity, to alternatives) understand that ESG issues have a strong impact at the P&L level, ranging from customers’ opinions of large corporate brands to carbon emissions for airlines. ESG analysis capture risk elements that traditional analysis fails to consider, such as: Production Process, Labour Conditions, Environmental Impact, Community Relations, Human Capital, Good Management and Corporate Governance, Diversity Management, Subsidiaries Activity, Balance Sheet Transparency, and Innovation Capability.

ESG rating agencies boasts each own proprietary databases covering several thousand issuers and specialising in different asset classes (equity, fixed income, alternatives and micro- finance). We personally specialise in investments in emerging markets, especially India and China, where we have been operating through local partnerships.

Furthermore, ESG research has recently broadened the scope of the scrutinised sectors, including alternatives investments.

Research methodology and the aim of analytical rigour

Following its launch, proprietary ESG research methodology has developed rapidly through the constructive comments received from the academic and financial worlds and contributions from publications by institutions such as the Global Reporting Initiative (GRI), Chartered Financial Analyst (CFA) Institute1 and UNEP-FI.

The concept of corporate sustainability still includes the firm’s impact on stakeholder (including shareholders and the community within which the company operates its business, employees, suppliers and customers), but the research objective is to assess and monitor, through analysis, a firm’s strategy, operational management and conduct vis-à-vis society and the environment.

These aspects are considered as indicators of the quality of the process and management of the firm in question. The final assessment is based on the firm’s soundness in terms of environmental and social performance and corporate governance structure.

Analytical rigour

At this stage of the research model’s development, the main focus is on the rigour of the analysis, which means both implementing a standard, rule-based procedure and checking the data and information collected.

Sector analysis becomes part of the information-gathering process, while the choice of sectors to be excluded (that is, alcohol, tobacco, pornography, nuclear energy, military/ defence, GMO, contraceptives or gambling) is left to customers, consistent with the ethical values they express or represent2. The reason for this attitude lies in the belief that “the primary spur of ethical investing is the internal value system of the investor, while the prompt for sustainable investing is the external realities of an economy out of balance3.”

Structure

Company ratings are based on analysis and assessment of a set of environmental, social or governance (ESG) indicators and awarded following examination of a broad range of public sources - including sustainability reports, annual reports, corporate websites and specialist information providers - and, in certain circumstances, internal company sources - often the company’s Investor Relations department.

The environmental, social and governance areas are the pillars on which analysis is based; each area is subdivided into categories.

In its turn, each category is structured around various aspects and each aspect is defined by a series of indicators, with the level of detail increasing along the way. Our model uses more than 100 ESG indicators, declined at sector and geographical level, to take industries and national peculiarities into the most accurate account.

Categories

The ESG evaluation is divided in different categories according to proprietary parameters, in our case as follows:

Environmental assessment includes five main categories, organised around various aspects:

Environmental Analysis Environmental Strategy and Policy Environmental Management

Products (section with aspects and indicators varying according to sector)

Production Process (section with aspects and indicators varying according to sector)

Social assessment includes three categories, organised around various aspects:

Social Analysis, Employees and Human Capital, Community Relations, Governance assessment includes three categories, organised around various aspects: Corporate Governance Analysis, Markets,  Corporate Governance and Shareholders.

Analysing a company requires assessment of all categories, aspects and respective indicators in order to reach an overall sustainability (ESG) score and therefore an ESG rating.

As shown in the list of analysis categories, the model provides for a section with specific indicators for individual sectors within the “Products” and “Production process” categories. Ad hoc indicators are used to consider the specific features of each sector, in terms of the environmental impact of the products and production process.

In this way, analysis of the impact of the products and production processes of an oil company, for example, is based on indicators other than those used to assess a finance company. The assessment of alternative investments’ alpha generation capabilities and related risks are scrutinised according to different parameters, such as: Corporate Governance, Performance, Sustainability, Human Capital, Cost Structure, Transparency, Portfolio, Compliance & Regulation, and Litigation.

Indicators

Indicators cover all the non-financial areas relevant to the company, according to state-of-the-art academic, scientific and economic research.

The model provides that each indicator should have a closed series of responses. Each response is associated with a score, which can be positive, negative or nil depending on the nature of the aspect under examination and the firm’s conduct in that regard.

At this level, analysis is supplemented by comments from the analyst, underpinning the explicit judgement concerning the indicator and quoting the reference documentation supporting the assessment. As indicated previously, the supporting material is made up of public information and documents, such as environmental and sustainability reports, annual reports or thematic or industry studies. The same analysis model is applied during sector analysis.

Analysis is designed to take a predictive approach, i.e. to identify the firm’s general attitude in relation to the main ESG topics, so as to anticipate its likely behaviour.

Forward-Looking Approach

In particular, if there are negative episodes, such as legal proceedings, judgments or terms of arrangement, the analysis aims to place the episode in context.

This process includes considering the potential or actual impact on the income statement, the type of corporate liability (fraud, fault or force majeure), the timescale (i.e. whether the episode refers to recent events and whether it has happened before), the company’s reaction and possible complicity by other firms. The aim of this approach is to identify in what way and to what extent the company is involved and how it is reacting: a score is awarded depending on the situation – i.e. the combination of events.

Final assessment

The overall rating is the result of the sum of the scores awarded against each indicator: the greater the final score, the higher the overall ESG rating.

The company’s assessment is determined by the process of analysis: the rating provides a synthetic indicator of the sustainability of the company in question.

The process of analysis allows attention to be centred on one or several specific aspects of corporate sustainability performance.

For example, it is possible to focus attention solely on environmental performance or the business’s consistency with the principles expressed in the Global Compact.

Significant, comparable results can be obtained by adopting a common base of indicators for all firms and a set of specific indicators in relation to the features of the various industrial sectors.

Index construction

Index providers use ESG assessments in order to structure specialised indices and customised products for their clients, which range from asset managers, pension funds, endowments, foundations, hedge funds and private qquity.

ESG indices serve numerous tasks, such as benchmarking, investment analysis, performance measurement, asset allocation and portfolio construction, the creation of index funds tracking specific ESG mega trends, ETFs, OTC and exchange-traded derivatives and other structured products catering to the asset management, investment banking, insurance, investment advisory, private equity and securities trading industries, among others.

Global Equity Indices: they give investors exposure to SRI/ESG investments tracking mainstream Global/Regional classifications

Thematic Indices: they are devised in order to generate absolute returns measured against conventional financial benchmarks through investments in some of the highest ESG-rated companies and through the most relevant long term investment themes, for example investing in the areas of renewable energies, commodities and agriculture.

Thematic indices aim to provide investors with an exposure to companies which are properly equipped in order to sustainably capitalise on long term fundamental issues, such as the increasing scarcity of water, the global demographic increase and consequent shortage of resources; and new opportunities such as underpenetrated sectors in emerging markets and technological innovations to fight off global warming.

Bond Indices: designed to provide exposure to fixed income investments by integrating SRI/ESG risk reduction potential into the selection process

Strategy Indices: designed to combine quantitative investment strategies, ESG risk reduction and alpha generating potential into an instrument that reproduces the investor’s desired risk/return profile.