Investment professionals choose to adopt responsible investment principles as guidelines to make sure their business conduct leads to more sustainable, responsible and profitable investments. Investment managers need to understand the impact of environmental, social and governance (ESG) risks on their portfolios by incorporating ESG factors into their investment processes.
The ESG approach focusses on the risks related to ESG factors and guides the implementation of risk-mitigating approaches in the investment process. Formally incorporating ESG into the investment process ensures the improvement and continuity of responsible investing. It makes the reporting of ESG systematic and repeatable, which enhances transparency, and enables better decision making by investors.
While simple in theory, this can be challenging to implement and requires a clear consideration of the relevant trade-offs.
South Africa has a relatively small universe of investment opportunities. This has direct implications for the implementation of ESG-based investment practices. It is not always easy to simply exclude a share, for example British American Tobacco. The sale of tobacco has social costs, but the company has also generated stable returns for shareholders. Exclusion is an opportunity cost from a fundamental research and portfolio construction perspective. ESG can therefore also be applied on a relative basis, where investment managers consider ESG scores relative to their sector and to the company’s historical score.
Impact investing is a distinct sub-set of ESG-based investing. Investments are made into businesses that explicitly aim to have a direct and measurable positive effect on society and the environment. However, these investments also need to be financially viable – impact investing aims to combine intentional impact and adequate financial returns.
The impact investing approach moves the industry towards integrating sustainability directly into their underlying investments. Investment managers in South Africa have refined impact investment objectives to be consistent with the goals of National Treasury for structural reforms.
ESG can be integrated across all asset classes, by incorporating it into valuation models or portfolio construction. The investment manager can use a set of criteria, qualitative and quantitative, to score companies individually in terms of ESG risks. Quantitative and qualitative risks can be determined for each company by scoring them on the individual components of ESG.
To compare ESG scores across industries, ESG components can be weighted based on the industry or sector characteristics by identifying the materiality of ESG factors affecting specific sectors.
Subjectivity is inherent in the implementation of ESG into an investment approach. ESG risks are many and diverse, and not always easily quantifiable, which makes measurement a challenge. However, just as any type of analysis by different investment managers will have subjectivity, so too will ESG analysis.
ESG factors are intertwined, influencing one another and affecting a business in its entirety. An investment process, where ESG is not integrated but a separate step (conclusions are drawn independently from company analysis), can lead to the erosion of the benefits of ESG analysis, because an investment manager is less likely to adjust investment decisions based on information that wasn’t part of the company analysis from the outset.
We perform an annual responsible investment rating assessment of investment managers to allow us to better understand how far along they are on their responsible investment journey. This rating complements the appointment, monitoring and reviewing process of the investment managers.
At Momentum Investments, integrating ESG into investment management practices is a key part of our responsibility to our clients. We focus on all of this because it is important to our investors, and what is important to our investors is important to us. Because, with us, investing is personal.
Watch our video on our investment in Rise Student Village here.
Watch our video on our investment in Ilangalethu Karoshoek Solar CSP 1 here.
Visit our page on Responsible Investing here.
To read our latest Stewardship Report here.
Latest report: here
Mindfields: The ESG edition research here