A new white paper from the Investor Responsibility Research Center (the IRRC Institute) in conjunction with Sustainalytics looks at the various approaches that investors, institutional investors in particular, might and do take to integrate ESG issues into their portfolio decisions.
Specifically, the IRRC and Sustainalytics, two Manhattan-based research groups long active in the field, offer what they call a typology of approaches to integration.
There are three dimensions involved in charting these approaches: who does the integrating, what is being integrated, and how the integration takes place. There are questions, in other words, of management, research, and of application.
There are six prevailing types which can be mapped onto their distinctive locales in this three dimensional space: the Believer, the Cautionary, the Statistician, the Discretionary, the Transition-focused, and the Fundamentalist.
The Believer holds that the process must be managed in a centralized way, with the benefit of narrowly focused research using “unmodified inputs.” Further, the Believer applies a top-down approach to the application of ESG.
What does all that mean? A top down approach takes a general view of how environmental, social, and governance factors create investment risks or opportunities. This view may, the report observes, be based on macro level analyses, which “facilitates positive or negative views on entire industries or markets.”
The top-down approach would include the view that a company involved in the extraction of thermal coal faces regulatory risks and should either be excluded from the investment universe altogether or underweighted in recognition of that risk.
The Believer uses unmodified inputs. That means that an institution run according to this type will adopt trusted external sources for the ESG data that bears upon its investment thesis. This approach is in contrast to a use of “modified” inputs, as when an in-house team takes its own view of which factors are most relevant to which industries or regions.
To say that the approach will be centralized (for the Believer) is to say that it will involve dedicated ESG experts or teams, in contrast to the more decentralized approach of leaving particular portfolio management teams responsible for carrying out ESG-related analysis in their separate silos.
When the typologists speak of “narrow” research in this context, they mean research on company-specific material and trends. To continue our earlier example: a Believer institution may have adopted the view that the extractors of thermal coal should be underweighted, based on the extent to which their bottom line depends upon that particular activity. Working from this top-level view downward, the Believer then asks the narrow questions: does company ABC extract thermal coal? And, how important is that to ABC’s bottom line?
The Cautionary and the Others
The other types can be understood as a series of steps away from the true Believer model. A Cautionary investor is in most respects akin to the Believer. This type of investing institution, too, uses a centralized process, narrow research, unmodified inputs. But its research process is from the bottom up, that is, issuer-centered, “with the primary goal of managing idiosyncratic risk that may stem from ESG factors, such as involvement in major ESG controversies,” as the report puts it.
The Statistician also uses the centralized process and narrow research. Yet the Statistician modifies the inputs of the external sources whence those inputs come. Indeed, for an institution of this type, as the report says, “much effort goes into identifying factors likely to contribute positively to future financial performance,” and this effort results in modification of the inputs. The Statistician, like the Believer, sticks with Top-Down integration.
The Discretionary is the last of these types that uses the centralized approach. The Discretionary also, like a Believer, uses narrow research and unmodified inputs with regard to ESG. The distinctive feature of this style is simply that its application can’t be properly considered as either top-down or bottom-up. Indeed, the report makes it seem haphazard. For such types, ESG staff supports portfolio managers “on an ad-hoc basis” to a process “to endure integration through reporting protocols is typically not present.”
We move at last to the two Types that employ a decentralized management. One of these is Transition-focused. The name comes from the broad thesis that the institution’s goal should be to align its investments with society’s transition to a more sustainable economy. This type of institution’s research will be wide-ranging (“broad” rather than “narrow,”) and will involve modification of the inputs. Application will be top down, with themes such as “climate change, water scarcity, and healthy eating” acting as the sources of idea generation, factors in the construction of the investment universe, and sector weight considerations.
The other decentralized management system, and the final type, is the Fundamentalist. The term bears its financial, not its ecclesiastical, significance here. Portfolio teams in such an institution “do not usually treat ESG research and analysis as distinct from other elements of their financial analysis.” The big difference between the Transition-focused institutions and their Fundamentalist kin is that for the latter, the application is bottom-up. Teams within such a fold will “often conduct scenario analysis to forecast the possible outcomes of ESGH controversies, or improved ESG performance.”