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What is ESG integration?

Rapidly accelerating macroeconomic trends, such as technological advancements, climate change and shifting socio-demographics will lead us to an era that will be quite different from the present. As the global economy and the social landscape change, these changes could create new risks and provide new opportunities for investors in the coming years.

Evidence is mounting to prove that companies that address non-financial environmental, social , and governance (ESG) risk factors like work environment (including contemporary slavery) as well as climate change and who are focused on good governance are also more successful over the long run.

One of the biggest researches in this field, Deutsche Bank and the University of Hamburg examined more than 2,000 research studies related to ESG integration and financial performance. They concluded it was true that ESG Integration did not negatively impact investment returns in the majority of examined studies. In fact generally it actually added value.

Similar to that, MSCI ESG data demonstrates that firms that have more ESG ratings typically have gross profit margins that are greater than the general market (see the graph above). A study conducted by MSCI goes even further and found that businesses with higher ratings for ESG were more likely to show better financial performance of their companies (controlling other aspects like size, quality, and).

Additionally, the gap in return between the most and least ESG-rated firms appears to have increased in recent times, with it being at or near 2.9 percent over the last five years (2015 until 2019).

In turn, the demand from pension schemes for investment in companies with solid ESG profile is increasing rapidly. For this reason trustees and consultants as well as asset managers are seeking a greater understanding of ESG elements that can have the greatest impact on the financial performance of an investment.

ESG integration is a way to do this. The term is defined as part of the Principles for Responsible Investment (PRI) as “the explicit and systematic integration of ESG concerns in the analysis of investment and decision-making about investments” It assists investors by identifying and addressing ESG risks, along with other financial information to assess the goal strategy, the quality of management, and the strategy of businesses. This all will affect the company’s performance and will be related to the return on equity.

The advantages of ESG integration could be summarized as follows:

* Improving the performance of corporates

The long-term financial benefits that comes from ESG Integration at the corporate level is that improved ESG practices will improve the company’s financial performance as well as financial value.

* Strengthening long-term future investment returns

ESG information and indicators help improve portfolio construction and the stock selection process. This could help to create more long-term value as well as reduce ESG risk.

* The progress in ESG integration improves valuations as well as return on investment

Companies that invest in those with more momentum ESG ratings are likely to experience more significant growth of their fiscal performance, which leads to better valuations and higher return on investment.

* Stronger resilience to extreme risk-related events and lower volatility

The real-world examples illustrate that not taking care of the financial risk posed by ESG issues can have a significant impact on the company’s performance, and also adversely affect shareholder value.

These advantages mean that ESG factors are expected to play a more significant and consistent part in determining the strategy for asset allocation, portfolio building and selection of managers. It will also be essential to support strategies’ long-term perspectives and complementing the traditional analysis of financials as a part of the decision-making process for investment.