For those data scientists who are new to finance and ESG investing, we’ve decided to put together a quick article outlining how we think about ESG problems. If you need a quick recap on what ESG is, check out our previous article here.
If not, here is a workflow we use to structure our thinking on ESG. As you can see, we break it down into 4 main sections:
Step 1: Identify the critical ESG issues for the sector
To start off the process it is important to identify which topics are important in different industries. For example, water pollution and labour rights may be key issues for a manufacturer while the leading issue for a software provider might be data protection. If we built a model that heavily weighted water pollution for each company we would find that many unscrupulous companies would score highly.
Step 2: Sector/Company-specific research
Next, we take the information we’ve learnt in step 1 and start conducting company or sector-specific research. Here I’ve listed some of the things you might start considering, it is not exhaustive even for the general case.
a. Controversies Research:
Identify notable incidents (think news-worthy: e.g. lawsuits, oil spills, cars catching fire) from news. Take this information and rank risk based on the frequency of incidents, the reputational risk from that type of incident and potential impact on stakeholders and the environment. These factors may well change over time as public opinion changes and priorities change. e.g. BMW
b. Corporate Governance Research:
Here we would look at factors that affect a company’s governance. This could include Board Integrity & Quality, Board Structure, Remuneration (e.g. multiple of CEO to frontline), Shareholder Rights, Financial Reporting and Stakeholder Governance. e.g. WeWork
As it says on the tin. What is the company/sector’s involvement in the carbon cycle. Do they use renewable energy, green transportation; in fossil fuels, including thermal coal, oil and gas, oil sands, shale energy, deep-water production and Arctic offshore exploration; scope 1 and 2 GHG intensity and emissions. e.g. BA / Virgin
d. Product Research:
Does the company’s products and services positively contribute to UN sustainable development goals or is the company on an exclusion list. e.g. P&G
e. Reputational Risk:
Public companies selling arms to sanctioned countries or ones where there is a high risk of violence against civilians, If the transfer would violate relevant international agreements, e.g. illicit trafficking or arms embargo or companies involved in controversial weapons. e.g. Google
f. Human Rights:
How does a company’s business activities affect people’s basic human rights? Does the company normalises, facilitate, expand or enforces human rights violations in a country. What about the opinion of the people in the countries they sell in? Is there reported violations of human rights, or the provision of tailored products and services, or other items that benefit perpetrators. e.g. Nestle
Step 3: Sovereign Analysis
Next, you would need to understand the operational risks the company is taking on by operating in a certain region or country. Again, these are just some examples.
a. Natural & Produced Resources (e.g. what is the quality and availability of infrastructure, energy supplies and natural resources),
b. Human Wellbeing (e.g. Do employees and their families have access to water and sanitation, mean years of schooling and life expectancy)
c. Institutional Risk (e.g. how strong is the rule of law, is there widespread corruption and political freedom?)
d. Identify countries subject to UN, US, EU sanctions, and signatories to international norms or undergoing civil conflicts etc (or potential conflicts/civil unrest)
Step 4: Forward-looking
Once you’ve managed to predict all of this you’re in a good place. However, the game changing edge comes from being able to see these changes and issues before other people – allowing you to make the trades before other people have priced it in. For example, for you to have invested early in battery technology, you had to be predicting the rise of electric cars and societal changes to tackling climate change. In a general way: How do sustainability trends can positively or negatively impact the company’s business model, its value chain, products and services. Some areas of interest you might want to look into: The circular economy, decentralisation of power networks, 0 car policies in European cities.
You can put these skills to the test in one of our ESG problems: quant-quest.auquan.com/competitions