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Commentary: ESG integration aids in investment analysis and decisions

Environmental, social and governance (ESG) is no magic wand but it is a key part of the analytical toolkit for investors and companies writes Wai-Shin Chan, co-head of ESG research at HSBC.

ESG issues among the general public have grown rapidly in recent years. Consumers increasingly consider sustainability, diversity and labour conditions when they buy.

Companies need to take that into account – but so do investors. The incorporation of ESG analysis into investment decision-making will only grow. However, we need to consider what this means for different stakeholders.

Fund managers face growing pressure from their clients to have an ESG framework that allows them to incorporate the issues into their investment analysis and decisions. Companies will be subject to more questions and scrutiny from investors, facing demands to disclose timely, relevant information and data. And regulators are increasingly embracing ESG compliance, moving from voluntary disclosure to ‘comply-or-explain’ and even some mandatory requirements.

HSBC’s ESG Integrated report series has looked at sectors from retailing to telecoms to identify the issues relevant to each industry, highlighting why these issues are important, what information and data are available, and how ESG issues can affect a sector in the future.

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But identification is just the first step. Ultimately, we plan to fully integrate ESG issues into our stock coverage framework, adjusting our financial forecasts according to whether these issues are risks or opportunities.

Environmental, social and governance issues affect the future course of a company – positively or negatively – but may vary across different time horizons and depend on how well the business addresses the issue.

ESG is evolving rapidly. We advocate using an integrated approach that uses an analytical framework to enhance the existing investment decision-making process. Rather than assigning scores or ratings, our integrated approach focuses on the issues that are, or will likely become, material for businesses.

Scores and ratings can be a useful starting point to help identify those areas that require more attention and deeper analysis but only if they are transparent and consistent. Different ESG issues are more, or less, material to different sectors, for instance; the availability of information varies hugely and the quality of data for specific issues is inconsistent.

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For example, the water policy of a technology firm cannot be compared with the safety record of a mining company or gender diversity at a food retailer be compared with working conditions at a fashion house.

Even within a single ESG issue, the importance of water usage at an internet firm differs from a beverage company’s usage. Thus any weighting applied to an ESG issue should be dependent on its materiality to a company over a time frame.

Reducing ESG to a score or rating detracts from the qualitative analysis of how the issues can affect the risks and opportunities facing a company, and investment analysis should be forward-looking while data is historical.

ESG integration allows greater focus on issues more material to a sector or company and can better capture the sustainability risks and opportunities. It can also be incorporated into existing investment analysis, be included in financial modelling, is forward-looking and encourages understanding of the qualitative aspects of a business.

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