How ESG factors can help investors make more informed decisions

A deeper dive into a company's fundamentals can provide valuable insights to build portfolios that will generate long-term returns

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With sustainable investing becoming more prevalent, more investors are factoring environmental, social and governance (ESG) data into their decision-making.

This year, we expect to see continued issues from the pandemic and its associated economic and societal implications.

For investors trying to position and navigate their portfolios through the uncertainty, considering ESG can provide a valuable perspective on the material factors affecting companies in 2021.

It is important to note that ESG factors are neither static nor exhaustive, but rather they highlight challenges companies might face and which investors may want to understand.

Environmental factors

The pandemic may have moved environmental awareness down the global agenda as they focused on more pressing issues. However, climate breakdown has continued relentlessly and will likely regain pace as output recovers.

With hopes of a vaccine being distributed soon, we expect more attention to return to environmental factors, notably in carbon emissions and biodiversity.

Social factors

Social factors have generally not received the same attention as environmental and governance ones. The comprehensive and pervasive effects of the pandemic across industries and countries seem to have made social factors more universal and a priority for investors.

How companies managed their relationships – with employees, suppliers, customers and in its communities – became immediately evident and comparable. We expect, as the economy attempts to recover, attention to grow next year in two areas in particular: employee safety and labour management.

Governance factors

Even before the rise of using ESG factors, governance has been a long-standing, non-financial consideration for many investors. It covers a broad range of corporate activities such as board and management structures, shareholder rights management, remuneration and incentives, board diversity, corporate policies and standards, information disclosure and ethical behaviours.

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With hopes of a vaccine being distributed soon, we expect more attention to return to environmental factors, notably in carbon emissions and biodiversity

Last year, we saw widespread calls for more gender and racial equity along with social justice and reversal of globalisation. While these issues will continue into, and beyond, 2021, two aspects are material for investors – the robustness of corporate governance and alignment of executive remuneration.

Using ESG to select quality investments

The reality is investors consider a variety of factors when deciding whether to select, or hold, an investment. Adding ESG factors can enhance existing investment processes by including non-financial information – hopefully to make more informed investment decisions.

Traditionally, investors’ primary data points have been financial ones, with sources such as annual reports, management presentations and earnings statements. Several traditional performance indicators may be disrupted this year, therefore, relying solely on this information may limit the ability to select companies that will perform better in such challenging conditions.

The core premise is that by considering ESG factors, an investor can take account of a broader set of data to make a better judgement about the financial performance and longer-term value of a company. However, not all factors are equally relevant to all companies.

Given the wide range of ESG issues a company may face, an investor should narrow them to a set that is most relevant and translates into financial performance, impacting either free cash flow or eventually the cost of external financing. This materiality is important to identify which of these factors will influence, positively or negatively, a firm’s business model and value drivers.

Having determined the material ESG factors, investors can identify where a company can be at risk or have an advantage relative to its peers. For example, organisational practices and culture can affect a licence to operate or make a company more or less prone to scandals or fines.

By introducing leading environmental sustainability practices, greater operational effectiveness can be achieved. Or greater connection with employees and customers can be made through a company’s market positioning and activities.

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Additionally, investors also have various options in how they assess and integrate ESG considerations into investment practices. While “ESG investing” is generally discussed as a homogeneous practice, there are substantial differences in investors’ approaches. At the broadest, two methods emerge – screening or incorporation.

Screening on ESG factors relies primarily on using either a single metric or a rating, which are a composite assessment of the relevant data points, calculated through weighing mechanisms. Investors can use the ratings from various agencies (such as MSCI, Sustainalytics, FTSE Russell or Refinitiv) or develop their in-house rating systems.

Incorporation, on the other hand, is a more nuanced approach, where investors include ESG factors into their investment assessment, discussion and decision-making. This can mean using ratings as part of the process, but they also tend to delve into the accompanying qualitative research reports and underlying data to the factors. With an incorporation approach, ESG becomes one of the factors to inform decision-making rather than a rigid, filtering one.

If investors can use ESG insights to understand better the complexities of associated risks and opportunities in how companies operate, they can position their portfolios accordingly. Additionally, more widespread use of such considerations and requirements to report such data may help encourage companies to make a positive change in how they operate on these factors.

In what looks like being a low-return era for investors, ESG integration provides additional tools for investors to select companies and build portfolios with the aim of generating long-term returns for 2021 and beyond.

Damian Payiatakis is the head of sustainable and impact investing at Barclays