How Investors Integrate ESG: A Typology of Approaches. May 8, 2017

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Gertrude Casey
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1 How Investors Integrate ESG: A Typology of Approaches May 8, 2017

2 Agenda Logistics & Intro Why This Research Methodology Typology Dimension 1: Management Dimension 2: Research Dimension 3: Application Prevailing Types Market Observations Conclusion Q&A 2

Webinar Logistics Attendees are in listen only mode. But, questions are encouraged. Type using the Question function, and we will answer following report overview.

3 Webinar Logistics Attendees are in listen only mode. But, questions are encouraged. Type using the Question function, and we will answer following report overview. Session recording, replay will be posted at Share webinar info on Audio issues during webinar, contact

4 Speakers Jon Lukomnik, Executive Director Investor Responsibility Research Center Institute Kevin Ranney, Director Sustainalytics Doug Morrow, Associate Director Sustainalytics 4

About Investor Responsibility Research Center Institute Not- for- profit established in 2005.

5 About Investor Responsibility Research Center Institute Not- for- profit established in Funds, disseminates objective, unbiased research on range of issues at intersection of corporate responsibility, investors informational needs. Academic & practitioner research examining capital market context that impacts how investors, companies make decisions. Annual research award with two $10K awards. Deadline October 6, More than 60 research reports available at no charge. 5

research, ratings and analysis 13 offices with 330+ staff Coverage

6 About Sustainalytics Sustainalytics has 13 global offices Sustainalytics is a global leader in ESG and corporate governance research, ratings and analysis 13 offices with 330+ staff Coverage universe of 6,500 global equities Over 300 institutional clients across 22 countries 6

7 From IRRCi Perspective ESG has gone mainstream $22.9 trillion is managed with some type of ESG analysis For a many asset managers, some type of ESG Integration is virtually mandatory Tenders / RFP s from asset owners Attract talent Result: Many, many investors claim to Integrate ESG into their investment processes. To the point that ESG Integration had become a meaningless mantra that made people feel good but had limited descriptive use. 7

8 From IRRCi Perspective What does ESG Integration really mean? ESG Integration included everything from detailed mandatory consideration of the most sophisticated analysis to superficial greenwashing Hard for asset owners to really understand Even sophisticated beneficial owners get frustrated Confusing semantics Lack of disciplined process understanding makes it difficult to analyze how asset managers use ESG factors in their investment processes Frustration led IRRCi to issue an RFP for a granular typology to analyze ESG integration into investment processes on a granular level: who, what, how. 8

9 From IRRCi Perspective Investors now have an analytical framework to understand not just if ESG factors are being taken into account, but how that particular form of ESG integration affects investment processes and portfolio construction Typology provides the equivalent of style analysis Enables us to understand who integrates ESG, what is being integrated and how it is being integrated. Enables a common semantic framework. Instead of fundamental, small cap value manager we can now say centralized ESG resources with mandatory consideration at the security level (The Believer) or mandatory, top- down thematic consideration of ESG risks and opportunities (The Transition- Focused). 9

10 An analytical framework to organize approaches to ESG integration Commissioned by the IRRCi Objective: help investors navigate the rapidly evolving responsible investing landscape by developing a typology that classifies approaches to ESG integration Builds on existing literature (PRI) Value for different audiences Stakeholder Asset managers Asset owners Retail investors Benefit Identifies the essential characteristics of ESG integration strategies Supports the assessment of asset managers' ESG capabilities Informs the selection process for investment advisors or products 10

11 Methodology Defining ESG integration Scope and limitations Initial framework of 18 indicators 70 investors with collective AUM of USD 19.9 tn 35 semi- structured interviews (non- attributed) 35 firms analyzed through public disclosures (PRI Transparency Report) Initial framework Desk- based research and investor interviews Typology Six prevailing types 11

12 The typology is based on three core dimensions Three core dimensions: Management (who is integrating ESG?) Research (what is being integrated?) Application (how is integration taking place?) Within each dimension, we identify two key differentiators Core dimension Summary Shorthand Key differentiators Management A focus on how different functions, ESG- relevant roles and responsibilities are structured within an organization. Who is integrating ESG? a) Degree of centralization of ESG functions b) Process to ensure ESG integration Research A focus on which types of ESG information and analysis are integrated into the investment process. What is being integrated? a) Scope of research b) Modification of ESG inputs Application A focus on how and at what point ESG information and analysis are integrated into the investment process. How is integration is taking place? a) Top- down techniques b) Bottom- up techniques 12

13 Dimension 1: Management Key differentiators: 1. Degree of centralization of ESG- related functions 2. Use (or not) of processes to ensure integration Key findings: Trend towards decentralization Do reporting mechanisms work? The importance of team culture Process to ensure integration No process to ensure integration Decentralized ESG management Centralized ESG management

14 Dimension 2: Research Key differentiators: 1. Breadth of research 2. Degree of modification of ESG data Narrow ESG research Broad ESG research Key findings: The challenges of integrating broad ESG research Customized analysis Modified ESG inputs Unmodified ESG inputs

15 Dimension 3: Application Key differentiators: 1. Use of top- down techniques 2. Use of bottom- up techniques Less bottom- up ESG techniques More bottom- up ESG techniques Key findings: Using screens to enhance returns Limiting tracking error as a constraint More top- down ESG techniques Less top- down ESG techniques

16 Six prevailing types Management Research Application Prevailing types More top- down Less bottom- up The Believer Narrow Unmodified inputs Centralized Process to ensure integration Less top- down More bottom- up The Cautionary Narrow Modified inputs More top- down Less bottom- up The Statistician Centralized No process to ensure integration Narrow Unmodified inputs Less top- down Less bottom- up The Discretionary Decentralized Process to ensure integration Broad Modified inputs More top- down More bottom- up Less top- down More bottom- up The Transition- Focused The Fundamentalist 16

17 The Believer Executes ESG integration in a clearly structured and consistent manner. Investment teams focus primarily on narrow ESG research. Emphasis on top- down integration techniques. 17

18 The Cautionary Also uses centralized approach that focuses on individual companies, and has methods to compel integration. But unlike The Believer, The Cautionary relies on bottom- up techniques and focuses on company- specific risk. 18

19 The Statistician Seeks to identify correlations between ESG performance and financial performance. Like the first two types, uses centralized management and has a process to compel integration. Integration techniques are rules- based and, therefore, top- down. 19

20 The Discretionary Centralized management but no process to ensure integration. The research is typically unmodified third- party research about individual companies. Portfolio managers have wide discretion about how and whether to apply ESG research. 20

21 The Transition- Focused ESG factors are central research inputs in overall investment process. Unlike the first four types, The Transition- Focused relies on broad ESG research. Teams combine bottom- up and top- down integration techniques. 21

22 The Fundamentalist Integrates ESG factors thoroughly into bottom- up analysis. Integration responsibilities rest with investment teams. They often conduct scenario analysis to forecast the possible outcomes of ESG controversies, or improved corporate ESG performance. 22

23 Market observations The extent of integration: are some organizations overstating the degree to which their investment teams actually use ESG research? Bottom- up integration is particularly difficult. Continued concerns about ESG research, but notable improvement in recent years. Tracking error constraints may be stifling innovation. The lines between maximizing returns and minimizing systemic impacts are blurring. 23

24 Concluding thoughts Investors growing interest in, and use of, ESG information will lead to increasingly diverse integration tactics Raises the importance of organizing these tactics in an overarching analytical framework a typology It is hoped that the paper s core contributions identifying the essential features of ESG integration and six prevailing types help promote discourse and discussion As ESG integration continues to develop, it will be important to revisit and update the typology 24

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26 Contacts Kevin Ranney Director Sustainalytics Doug Morrow Associate Director Sustainalytics Jon Lukomnik Executive Director IRRC Institute

Passive Investors, Not Passive Owners Webinar January 14, The Investor Responsibility Research Center Institute

Passive Investors, Not Passive Owners Webinar January 14, 2016 1 Agenda Introductions Research Review IRRCi Perspective Q&A 2 Webinar Logistics Attendees in listen only mode. Questions encouraged. Type