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Measurable ways for performance teams to add value in esg investing

As the demand for environmental, social and governance (ESG) strategies is on the rise and assets under management (AUM) sits around $330bn across active and passive funds, managers need to demonstrate how they’re integrating ESG considerations into their investment process. Performance teams must work closely with the front office to portray manager conviction and ESG integration for reporting purposes. In doing so, challenges such as lack of alignment between vendor data or accounting for company climate transition plans can arise. There is no one-size-fits-all solution for this – managers are typically looking across multiple providers and must clearly show how they’re using differentiated datasets to add value.

Despite these challenges, there are ways performance teams can add value during the reporting phase. ESG integration starts with the front office team’s approach, but the presentation of performance reporting and analytics is of equal importance. Two measurable and tangible methods of integration used by performance teams are composite scoring and carbon analytics.

Composite scoring

Composite scoring is the process of incorporating multiple third-party vendor datasets. In some cases, this is done through the creation of proprietary ESG scores. Since there is value in several integration approaches, sophisticated managers can no longer rely on one source of truth for ESG ratings. Vendor correlations that are typically low can prove to be beneficial if the manager uses datasets that approach company performance from various angles. Having a company-reported lens is critical for managers to uncover the insights they need. However, the outside stakeholder perspective is equally important in assessing current risks and information that may not be typically disclosed. A holistic approach that uses both viewpoints can help managers avoid greenwashing and better assess both risks and opportunities.

On the reporting side, the performance team can more confidently display traditional security- and portfolio-level analytics. The composite score allows them to identify companies that are performing well or poorly from an ESG perspective. Performance teams can use the custom composite score to stratify returns or run performance attribution analysis. Some managers may even use it for back-testing in an alpha-generation use case.

Combining multiple datasets requires careful thought and collaboration as it must not disrupt existing pre-investment due diligence. Its primary use for composite scoring should be to corroborate analyst/manager analysis and create another potential mechanism for investment committee approval or exclusion.

Carbon analytics

Equally prevalent in the reporting space today is the use of carbon emissions data. While emissions data and coverage continue to improve, the data has a tangible nature for helping managers gain perspective at both the security and portfolio level. At the most basic level, many managers are using TCFD-specific carbon footprint calculations such as Weighted Average Carbon Intensity, Carbon Footprint and Carbon Intensity to model and compare portfolios against benchmarks. These calculations can help identify and explain which areas of the portfolio may pose more risk relative to an index. Managers can use them as inputs into the security selection process and then in reporting to concretely show how they are preparing their portfolios for a transitioning economy.

For example, a manager may examine Weighted Average Carbon Intensity at both the security and portfolio levels to see which companies are contributing the most to the overall score. This might be helpful when the manager is evaluating multiple portfolios to decide which ones are appropriate for specific composites.

Carbon Attribution can also be used to show exposure to emissions in a benchmark-relative fashion. In a simple Brinson-style analysis, you can use combined Scope 1 & 2 emissions to determine if you’re allocating well to areas of your portfolio that are emitting less than the index. From a selection standpoint, you can determine if you’re picking securities within the same benchmark groups that are emitting less than the index cohort.

Finally, Scenario Analysis is another tool that can be employed to determine how a portfolio will look in the future vs. an allocated carbon budget. It can reveal how well your portfolio will perform as well as if it can meet the specific scenario for temperature rises such as Sustainable Development Scenario (SDS) or Stated Policies Scenario (STEPS). When running an SDS scenario (targeting temperature rise of approximately 1.65 degrees Celsius by 2050), certain vendors can provide year-by-year breakouts of both budget and usage to determine if or when a particular portfolio might breach the temperature rise. With varying levels of certainty, these scenarios can help predict how your portfolio structure might need to change to align.

Implementing composite scoring and carbon analytics

As assets continue to flow into ESG and carbon-reducing strategies, reporting is becoming critical in illustrating manager approaches and fulfilling client requests. By using the previously mentioned methods, performance teams can more easily integrate and discuss how ESG datasets are impacting the performance and risk of their portfolios.

By James Cardamone, VP, ESG Product & Strategy, FactSet Research Systems, Inc.

Check out ESG Materiality Factors in the Fourth Industrial Revolution for more on this topic.