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The Common Challenges to ESG Screening

ESG factors are becoming increasingly important to prioritise for Portfolio and Fund Managers. We explore the different approaches to ESG screening.

Portfolio and fund managers are facing an increased need to prioritise ESG (environmental, social & governance) factors within the investments they manage.

Once seen as a ‘nice to have’ addition to investment strategy, ESG is now firmly established as having a tangible financial impact on investment return. A strong ESG ethos within a company means it is less likely to face regulatory issues or wider backlash, meaning that ESG is a quantifiable barrier against investment risk.

Meanwhile, ESG is also increasing in its importance due to legislation and regulation from both financial bodies, governments, and multi-national bodies.

All this makes ESG-led investment a complex landscape to navigate. There are a plethora of choices for investors to consider when strategising how to integrate ESG factors into their investment portfolios.

In this piece, we look to tackle these challenges head on. We’ll be looking at ESG screens as an overarching topic, exploring the correct criteria to use when considering investments through ESG’s lens, and uncovering the different approaches to screening ESG that are used in the wild. Let’s get into it.

(If you have a particular question or topic you’re searching for, use this menu to jump to it):

What is ESG screening?

This is a good place to start. ESG screening is a method of researching and screening investment opportunities to ensure they are responsible, sustainable and fair. This is predominantly looked at across three categories: environmental, social and governance – which we will dig into in more detail within the next section.

ESG is fundamental to differentiating your depth of market knowledge from the competition, in order to uncover hidden investment gems. Innovative new products & services, strong market positioning and an early identity as a thematic leader; this is what certain ESG screening and research expertise can give firms: an advantage over other investors.

Similarly, ESG screening can uncover issues that are yet to surface. One hypothetical scenario would be that a company whose pay structure is unfairly weighted towards leadership, being uncovered through thorough ESG analysis. Screening methodology often errs towards being too simple, and some of these crucial insights can be missed.

As we’ve mentioned, ESG screening is rising in prominence, reflecting a more aware & inquisitive investment industry. Having the competitive advantage to outperform the competition and generate alpha through investments means that ESG screening, thematic investing and impact investing have never been more important.

Defining the right ESG screening criteria

Defining the right ESG screening criteria is an essential first step in using this data and research correctly and achieving results. The issues lie in the sheer breadth of topics that can fall under the parameters of ESG.

There are three broad categories of environmental, social and governance issues. Here are just some of the factors that come under each:

  • Environmental: carbon footprint, waste product, recycling, renewable energy, animal welfare, biodiversity conservation, pollution prevention
  • Social: Equal opportunities, community ties, what the company produces, modern slavery, indigenous peoples, cultural heritage, forced resettlement, disability inclusion, LGBTQ+ safety
  • Governance: pay structures, representation, anti-corruption, ESG management and transparency, shareholder relations, health and safety, supply chain status

It’s clear that a great number of important issues fall under ESG’s umbrella; not to mention changing and new regulatory demands that need to be met. When undertaking ESG screening, it is important to establish internally or externally a strong understanding of the business in question and of the industry that they are part of.

Take recycling as an ESG example. You need to have enough expertise to sort through this immensely complex topic, encompassing resources, commodities, engineering, manufacturing, services and distribution models. It’s this level of understanding that enables you to identify those key investment growth opportunities.

Only with this can investment and fund managers be able to identify and research the ESG topics of importance for the opportunity, and confidently screen against it.

What are the most common ESG screen methods and the challenges with each?

If you are just starting to explore how ESG can be incorporated into your investments, or are curious to discover new ways of undertaking it, then it’s vital to know the different approaches investors currently take. There are three key ways that ESG research is carried out – all with their own benefits and challenges.

ESG Fund Screener

An ESG fund screener – sometimes called an ESG mutual fund screener – is a tool or consultancy service that lets investors understand the ESG profile of a potential investment. Typically, this begins by settling on a set of attributes which align with the criteria of the kinds of business they want to invest in. These are then used as the standards to check and measure against.

However these screens are broad, inflexible and not as deep as qualitative, in-depth research. So while you may be able to screen in or out companies initially, it can be hard to differentiate between those you’ve chosen to consider and uncover their true potential.

While some screening organisations rely on publicly available data, many have relationships with the businesses they are assessing, using proprietary data accessed through that relationship. This is usually a ‘black box’ approach, where it’s hard to assess the validity and sources of that data, as it’s kept under lock and key by the ESG fund screeners themselves as their USP.

Norm-based screening ESG

Norm-based screening is a broad, wide-scale screen that is often used early in the investment research process. It relies on screening issues according to international standards of business practice and law.

Usually it is substantial institutions that these standards are taken from: think governments, the EU, SASB, UN Council etc.

Sometimes referred to as ‘controversy screening’ for its use in dodging significant ESG issues, it is a vital early step to ensure that any entity you may be looking to invest in is operating legally and ethically.It requires a significant time investment to keep up with changes to existing standards and the tracking of new standards as they are updated and refined.

Regulators have imposing requirements for investors to report back on. The UN has 17 sustainable development goals (SGDs) and the EU an entire ESG taxonomy and a system for classifying funds’ ESG ratings, such as article 8 funds (promoting environmental or social characteristics) and article 9 funds (sustainable investment as their objective).

Just reporting on, let alone screening against, these requirements is a sizeable task.

ESG exclusionary screening

The origins of ESG exclusionary screening is an interesting story. It is said that it originated in the 18th century where the Quaker community, who were prominent investors, refused to engage with the slave trade from a moral and ethical standpoint.

Exclusionary screening in today’s financial world isn’t all that different. It is a screening method that excludes companies that don’t align with the moral or ethical outlook of a fund or investor.

We’ll talk more about the kinds of companies that are routinely excluded in the section below on negative screening, but the traditional ‘sin industries’ – tobacco, weaponry and gambling companies – are often the first to be taken off the table.

But exclusionary screens can also be used against companies in ‘safer’ industries that still violate the principles of those looking to invest. For example, a supply chain company that isn’t producing anything morally dubious, but has a terrible reputation for a damaging environmental impact, may well be excluded at this stage.

Much like norm-based screening, exclusionary screening is a broad strokes, first port of call that is focused on reputation management and avoiding hotly contested industries, but does little to unearth the best investment opportunities. As such, it would often need to be followed up with additional screening procedures once those first exclusions take place.

Positive vs negative ESG screening: what’s the difference?

All of the ESG screens already discussed can be approached via a positive or negative method, giving a different weight and approach to the results generated. Let’s dig in.

Positive ESG screening starts with a fund or fund manager identifying core ESG issues they want to use, and deciding how exactly to measure a company’s performance against them. From this, research is carried out looking for ‘best in class’ performance against these criteria to find the frontrunners.

This could be a straightforward target, referred to as an active ESG-positive target. This is where a company works in an ESG field and also works in a responsible way, say a recycling company with excellent environmental scores.

It won’t always be a business that works in the field of that particular ESG issue though. You could be investing in a construction company as a result of a positive ESG screening of renewable energy usage, where a particular firm comes out on top for using almost entirely renewable energy across their production line.

Positive ESG screens can also be implemented at a deeper level, with some specialists able to measure and predict a business’ ability to improve due to their ESG efforts. If there are two potential investments in the same industry, it could be that the smaller/less profitable of the two is the better investment opportunity because of a progressive approach to energy usage, community ties or transparent governance.

Negative screening is similar to exclusion screening, but based around specific ESG themes. With this approach, investors aim to avoid the very worst performers against ESG criteria. It’s also applied to industries that cause active harm (e.g. narcotics and weaponry) and screening those out from the investment process as soon as possible.

There is an argument that negative screening can have a detrimental impact on investment returns – when the industries that many steer clear of for ethical reasons are hugely profitable. But as with all investing, it’s not as cut and dry as it seems. For example, could you invest in a carbon-based energy company if they were putting large amounts of investment into becoming greener? The opportunity is there – if you can uncover that level of insight about their activity and help them to define and tell a consistent story.

Key examples of negative screening in ESG

We’ve mentioned the traditional ‘sin industries’ already, but negative screening can cover a host of different variables and filters to screen against. The include:

  • Sin industries: firearms manufacturers, alcohol and tobacco companies, gambling companies
  • Unstable regions: companies operating in countries and regions with active civil war, and those that have direct links to authoritarian governments
  • Political reasons: Withdrawing potential investment from countries that are actively subjugating another (much of the investment into Russian companies was removed or sanctioned with the invasion of Ukraine)
  • Major leadership controversy: Organisations that have had widespread criminal investigations or morally objectionable reports around current leadership

Negative ESG screening can be run through all of these different filters to identify the companies you shouldn’t put your money behind, but more ESG research still needs to be undertaken to uncover those you should invest in.

ESG screened vs ESG enhanced: how effective is each approach?

ESG screens are a cut and dry approach, despite having several different ways to approach them. The important ESG filters to a fund or individual are established, measurement against these is set, and companies are then researched and screened in or out depending on the results.

But there is a growing trend away from definitive screening towards ESG-enhanced approaches to investment. In this method for assessing ESG, it is used as part of a wider thematic investment process. The data steers and weights this broader investment research, rather than adopting an ‘in or out’ assessment for companies.

Naturally, it is harder to do and by manual methods would often take more time, but the results are a more nuanced, considered approach to ESG that balances it alongside broader themes, societal impacts and profitability of an investment.

Confused? See how our thematic ESG research solutions can help you make the right investment decisions

It’s clear that there is a lot to consider when integrating ESG into investment decisions. Difficult-to-obtain data, non-standard reporting, shifting regulation and different interpretations of results all add to the undertaking.

But in our eyes, ESG research is a vital part of the thematic investment process.

Through our Thematic Intelligence solution, Affinity, we’ve worked to create a tool that focuses on two key areas: providing deeper, more finely-tuned thematic data (including ESG), and vastly reducing the time it takes to undertake this research.

Affinity uses AI and a comprehensive and efficient screening process to tap into a global pool of clearly defined and relevant companies according to the themes and market events you want to focus on.

Affinity’s tailored, thematic approach means portfolio managers deepen their understanding of ESG factors by accessing unstructured data sources across topics, far beyond that of traditional providers. The usual information quantitative data sources are combined with financial reports, publicly available meeting notes, call records and news sources for a deeper understanding.

The result? The ability to focus on the precise ESG factors that are important to your investors, without compromising on your responsibility to generate returns from these investments.

To learn how to prioritise and enhance ESG compliance, transparency and performance with Affinity, our ESG research page is a good place to start. Or maybe we should talk.

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