The ABCs of ESG

Despite the endorsement from institutional investors, there is still confusion as to what constitutes ESG integration, says Melanie Adams, vice president and head of corporate governance and responsible investment with RBCGAM in Toronto.

ESG integration assesses companies in these three areas to identify where they may be vulnerable. Is there any forced labour used in the supply chain, for example? Are there enough women on the board?

As such, it’s critical to understand what is meant by environmental responsibility, social responsibility and good governance.

There is no one-size-fits-all set of questions or criteria, says Rosa van den Beemt, senior ESG analyst with NEI Investments, a division of Aviso Wealth Inc., in Toronto. “ESG considerations differ by sector.”

Take the environmental component of ESG. Greenhouse gas emissions, energy efficiency, and water and waste management are some of the key issues that investors will look at when evaluating a company’s environmental performance. But the weight given to each environmental factor would depend on its materiality in the industry, notes Dustyn Lanz, CEO of the Responsible Investment Association in Toronto. “For example, water management will be more important for evaluating mining and agricultural companies than it would be for banks and technology firms.”

Companies generally perceived to have high environmental risks, such as those in the oil and gas sector, are not necessarily eliminated. Many fund companies, such as NEI, take a broad-brush approach. “Oil is a foundation of the economy. You can avoid companies, but you can’t avoid the use of oil,” says van den Beemt. “Ignoring such a fundamental plank of the economy doesn’t seem responsible.”

She points out that because the oil and gas sector has significant environmental impact, companies operating in this space have a heightened expectation to address and mitigate those impacts. “They face a higher standard environmentally than other sectors because of their footprint. But companies just have to be better than their peers to make it onto various [indices].”

And companies want to be included, Adams says. “Generally companies would like to be included in as many indices and funds as possible. They are trying to disclose.”

Socially responsible criteria assess how a company performs on issues such as human rights, human capital management, diversity and stakeholder engagement. “Bad press is a headache for any investor, and bad press is often the result of issues such as human rights abuses or mistreatment of workers in the company’s labour force or supply chain,” Lanz says. “These kinds of controversies can create serious reputational issues for a company, which can lead to a selloff or downward pressure on its share price.”

Governance is the one area that is consistent across sectors, notes van den Beemt. “Whatever sector a company operates in, it still needs to be governed well, be responsive to shareholders, have accountability measures in place, etc.”

Governance is really a matter of the structuring of responsibility, accountability, risk oversight, incentives (including executive compensation), and shareholder and stakeholder rights, van den Beemt notes. Typically, governance indicators relate to the issues that get voted on at a company’s annual meeting, such as board composition and board diversity. Among the factors assessed are how responsive the company is to its shareholders and whether the company has a robust code of business conduct.

Adams recommends advisors take the initiative and discuss ESG investing and related issues with investors. “Advisors should be raising this with their clients. Studies indicate clients care more about this than advisors.”