Data on issues such as greenhouse gas emissions, labor practices and board composition may help identify today’s ESG leaders and laggards…
Are Your ESG Strategies Assessing Future Risks?
Understanding why sustainable investing strategies should be both historically aware and forward-looking
Sustainable investing offers another way to manage risk in portfolios. So naturally, investors may expect that funds using environmental, social and governance (ESG) criteria will help avoid companies with sustainability challenges and instead focus on companies with a greater chance of delivering long-term growth. One challenge to meeting this goal is that we believe most ESG scoring is primarily based on historical information.
Data on issues such as greenhouse gas emissions, labor practices and board composition may help identify today’s ESG leaders and laggards — but those rankings don’t necessarily reveal how companies might respond to sustainability challenges and opportunities in the future. That critical assessment should be informed by historical performance but must be complemented by a forward-looking approach to ESG analysis.
Following is an example of why it’s important to look at both a company’s ESG track record and indicators of its ability to handle future sustainability issues. We also explain three ways FlexShares has built forward-looking insights into several of our sustainable investing strategies.
COMPANIES WITH SIMILAR ESG ISSUES BUT DIFFERENT TRAJECTORIES
Imagine two companies operating in the same sector, both with similar past employee health & safety problems. Based on this information, these companies have the same risks and so may have been given similar scores through frameworks that are looking just through this lens.
But if we look more closely, we can see Company A, is continuing to operate business as usual, while Company B has developed a new series of training programs and safety protocols in its facilities. It has also established board-level oversight of these issues, with annual auditing to assess compliance.
In this case, Company B is taking proactive steps to safeguard its business from future liability and work stoppages, and potentially helped to improve employee morale in the process. We believe that the long-term outlook from a sustainability perspective for Company B is quite different from that of Company A — an important consideration for us when building an ESG-focused fund.
THREE WAYS TO ASSESS POTENTIAL FUTURE SUSTAINABILITY
While there is no way to predict the future, we believe these three methods can help gauge how companies are positioned relative to sustainability issues over the long term:
1. Analyzing future carbon risk
Climate change is forcing the world to transition to a low-carbon economy. How this transition might hurt or help a company’s performance depends on its exposure to climate- and carbon-related risks.
Climate change is forcing the world to transition to a low-carbon economy.
FlexShares’ ESG & Climate strategies start with historical analysis of a company’s carbon intensity by measuring:
This current exposure is complemented by a forward-looking assessment of exposure to future carbon-related risks. For example, utilities that are proactively shifting away from fossil fuels and toward renewable energy would exhibit a lower carbon-risk score.
This approach may help an index to avoid companies that may hurt long-term portfolio performance, while tilting toward companies that could be better positioned to handle the transition to a low-carbon economy.
2. Emphasizing corporate governance
Strong corporate governance is critical for financial management. It can also signal how effectively a company is managing sustainability issues. We look closely at governance indicators, such as:
Strong corporate governance is critical for financial management.
Governance issues are critical to balancing short-term corporate performance with long-term shareholder interests. That’s why we give governance metrics a meaning¬ful weight in the proprietary Northern Trust ESG Vector Score that drives portfolio construction in several FlexShares ESG strategies.
3. Using a consistent, forward-looking risk assessment framework for all ESG issues
The recommendations from the Task Force on Climate Related Financial Disclosures (TCFD) established a series of best practices for companies to manage and mitigate their climate-related risks. The core elements of this framework examine:
The recommendations from the Task Force on Climate Related Financial Disclosures (TCFD) established a series of best practices for companies to manage and mitigate their climate-related risks.
We believe this approach represents best practices for managing all material sustainability risks a company faces, whether related to health and safety, raw material sourcing or business ethics. That’s why we adapted the framework to apply to all issues, not simply climate, as part of the Northern Trust ESG Vector Score. We believe that having an approach that combines an historical assessment with forward-looking insights provides a consistent way to measure the potential direction of a company’s ESG risks and opportunities relative to its peers on long-term sustainability risks and opportunities.
As ESG reporting continues to evolve, we can incorporate new data that may further clarify a company’s sustainability today, and in the future.
Our thinking is that using a standardized framework has other forward-looking benefits: As ESG reporting continues to evolve, we can incorporate new data that may further clarify a company’s sustainability today, and in the future. We believe these insights will provide advisors and their clients additional ways to thoughtfully manage long-term investment risks and opportunities.