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Sustainable & Responsible Investments

Sustainable & Responsible Investments 2

Sustainable & Responsible Investments

Key takeaways

1. A wide of Sustainable strategies is available on the market, starting from simple exclusions and going varietyall the way to pure Thematic Sustainability strategies. Faced with many offers, it is increasingly important for investors as it helps them identifying the to assess materialistically the sustainability level of portfolios,most suitable sustainability strategies. Whatever you – e.g. respecting international define as your objectivesstandards, excluding controversial activities, promoting best practices related to environmental, social or governance (ESG) concerns, financing themes linked to ESG challenges, etc. -, we recommend you to make a comprehensive assessment from all these relevant angles to make sure that you assess the whole picture of your portfolio.

2. Lately, have undertaken to assist you in this exercise. Sustainability labels can be useful sustainability labelsinstruments to help investors identifying the investment strategies which truly integrate ESG aspects in their investment process and their portfolios. However, each has its own eligibility criteria, so we encourage you to review them prior to choosing which sustainability label you choose.

3. are also helpful information to assess the ESG profile of a company. Here as well, some caution is ESG ratingsrequired when interpreting these scores, notably as ESG scores tend to reflect the level of transparency of the companies held in the portfolio. A deeper analysis of the holdings composing the sustainable portfolio is recommended as it can highlight important sector allocation biases, which may give the investor a more accurate view over the ESG risks and opportunities the portfolio is exposed to.

Beyond ESG scores which are a good proxy of the ESG valuation of an investment, a portfolio’s level of 4.sustainability can also be appreciated by looking at the (both negative and actual impact of the investmentspositive) through impact measurement metrics. Such metrics are a suitable complement to ESG ratings, labels and analysis of holdings, as they focus on the actual sustainability achievements of companies, and are not influenced by their commitments and policies. Thus, impact measurement metrics provide investors with some concrete evaluations of the positive impacts of the companies held in their portfolios, notably their contribution to sustainable goals and challenges. Overall, rather than looking at their portfolios from one angle, we advise investors to review it from the four angles presented here. Doing so, investors will gain a more comprehensive view of their portfolios and be able to accurately determine “how sustainable is their portfolio”.

How sustainable is my portfolio?

With the growth of Sustainable finance, more and more investors are interested to know how sustainable their investment portfolios are. In this tutorial, we explain to you how to analyze your portfolio from an ESG perspective, on which criteria you should base your assessment, what pitfalls you should watch out for, and overall, how to focus on what is relevant and put aside what is irrelevant. In this tutorial, we put the emphasis on portfolios invested in companies. We will explore the topic of Sustainable portfolios invested in Government debt in our next Tutorial (number 4): “How is a country sustainable? Understanding ESG in sovereign bonds”.


From which Sustainability angle do you want to assess your portfolio? What are you objectives?

We focus here on how you can assess the sustainability level of your investment portfolio. But before we can do that, it is important to first define your objectives. You have to define for yourself what you consider to be sustainable and what not; which values you would like to defend. Your objective could be the protection against reputational risk first of all i.e. not financing sectors or companies, which are considered controversial and could affect the reputation of your investments. It could also be defending values and best practices and therefore financing the companies which are recognized as being exemplary in terms of societal licence to operate. It could also be financing solutions to societal and sustainable challenges such as climate change, hunger (i.e. how to feed the ever increasing world population?), health issues (e.g. looking for solutions for healthier food), etc.

There are plenty of objectives from different angles, as it is also the case in terms of approaches. We already mentioned this in our first tutorial: the seven recognized core Sustainable investment approaches defined by Eurosif 1 reflect the diversity of objectives and dimensions.

Sustainable investment strategies as defined by Eurosif

Approach Description Opportunities Risks

ESG integration Explicit integration of ESG risks and opportunities in traditional financial analysis and investment decisions based on a systematic integration process and appropriate research sources

Better informed investment decisions No impact on the investment universe i.e. no eligibility filter for securities

Credibility of the approach due to the various levels of real and systematic integration (integration versus greenwashing) Lack of sustainable and responsible investment convictions

Active Ownership Shareholder responsibility, i.e. voting for the shares in the portfolio and engaging with companies on ESG issues in order to influence their ESG behaviour or improve their disclosure level.

Effective commitment to improve operational practices. No impact on the investment universe - i.e. no eligibility filter for securities

Effectiveness of the engagement is open to debate Other investors required for a real impact Long and energy-intensive process

Sustainable thematic approach

Investment in themes or assets directly related to sustainability development. Thematic funds may focus on a specific theme or, on the contrary, on various ESG issues.

Clear ESG positioning based on thematic convictions

Impact on the investment universe according to the restricted or broad thematic focus Risk of hype effect and creation of speculative bubbles as a result of questionable portfolio diversification

Best-in-Class Selection of leading or best performing companies (and countries) in their universe, category or asset class, based on ESG criteria

Strong belief that ESG leaders outperform in the long run

Impact on the eligible universe - to varying degrees depending on the eligibility levels defined (positive screening)

1 Eurosif is the leading European association for the promotion and advancement of sustainable and responsible investment across Europe.


Exclusions Exclusion of specific investments or investment segments such as companies, sectors or countries from the investment universe based on ESG criteria

Clear ESG positioning based on strong convictions Clear situation - black or white Reputation risk at the centre of the approach and its implementation

Impact on the eligible universe - to varying degrees depending on the defined eligibility thresholds (negative screening) ESG impact open to debate

Normative screening Filtering of investments according to their compliance with international standards and norms

Clear ESG positioning based on strong convictions Objectivity of exclusions based on international recognition Reputation risk at the centre of the approach and its implementation

Impact on the eligible universe - to varying degrees depending on the defined eligibility thresholds (negative screening) ESG impact open to debate

Impact Investing Investment in companies, organisations and funds with the explicit aim of generating a positive social and/or environmental impact on top of financial returns. Investments are often linked to specific projects. Impact investing differs from philanthropy in two ways. On the one hand, investors maintain ownership of the asset. On the other hand, investors aim to generate a positive financial return (microfinance, community investments, social business funds, etc.).

Credible ESG impact Clear and comprehensible communication of the purpose

ESG impact can be measured in different ways Investor intentionality Access to and liquidity of projects Uncertain and volatile financial return

Source: Eurosif

For example, a good starting point is to review whether the portfolio respects some minimum requirements via a normative screening, and notably by assessing compliance with the United Nations’ Global Compact principles. Most Sustainable portfolios fully comply with these principles, so being invested in non-compliant companies will quickly tarnish the Sustainability credentials of your strategy.

A second way to look at your portfolio is to verify whether it applies exclusions of controversial activities (such as Armament, Gambling, Adult-entertainment, Tobacco, etc.) and/or of countries (e.g. dictatorships).

Besides, it makes sense verifying whether the managing company has an Active ownership policy, meaning that it supports Sustainability principles through voting in the general assemblies of the company it is invested in, and through engaging with the management of those companies.

Going beyond, you can review whether there are hard constraints on the portfolio in terms of ESG scores. Such so called Best-In-Class / Best-In-Universe filters prevent the portfolio managers from investing in companies with lower ESG scores, and may benefit the ESG quality of the portfolio. Indeed, external experts assess the sustainability profiles of issuers and grant these an ESG score.

Conversely, some strategies do not set any hard rule about the way they take ESG risks and opportunities into account, but integrate it in their fundamental analysis. Such approach is called ESG integration, and is generally less ambitious from a Sustainability perspective.


For all these approaches, a good way to measure how Sustainable your portfolio is, is to compare its performance with a reference universe. This gives you an idea whether your Sustainability screening actually helped improving the ESG quality of your portfolio, in comparison with its reference universe or benchmark index.

Yet, for some other types of portfolio, a comparison with a benchmark is not possible. Sustainable thematic strategies are specifically built around Sustainable themes (typically some Greentechs, Food & farming, Social or Health-related topics) through stock picking, and they are only invested in companies which are positioned to benefit from these topics. For such thematic strategies, you will need to look at the actual business-lines of the companies in the portfolio (i.e. at what do they produce / provide).

At last, Impact investing strategies take stakes in companies, organizations and funds with the explicit aim of generating a positive social and/or environmental impact on top of the financial return. This impact is measured through ESG Key Performance Indicators (KPIs). Those ESG KPIs give you an idea of the Sustainable impact of your portfolio.

The list above shows you that a wide variety of Sustainable strategies is possible, starting from exclusions and going all the way to pure Sustainable Impact strategies. Even combining different strategies is an option. Whatever you define as your objectives, we do recommend you to make your assessment from all the relevant different angles to make sure that you assess the whole picture of your portfolio.

Get the right ESG data

Now that you have defined your objectives, the second step is to find the relevant data.

Over the past years, a new ecosystem of so-called extra-financial research providers emerged. Specialized in the Sustainability analysis of companies and countries, as well as in the provision of sustainability related metrics, these research agencies offer valuable input for portfolio assessments. While some providers are specialized in certain areas like corporate governance or environmental criteria, others also offer more generalist services such as reviewing portfolios’ compliance with international norms, controversial activities screenings, and integrated ESG scores.

ESG scores generally result from industry specific sustainability rating models that group a wide set of environmental, social and governance criteria into one score. Common examples of such criteria include companies’ revenue exposure to Green-techs (Environment), the frequency of occupational accidents or the yearly average hours of training (Social), and the proportion of independent directors seating at its supervisory board (Governance). Typically, each company is rated on each ESG criteria which is deemed relevant for its industry. The ESG criteria are weighted, depending on their level of relevance for the industry group. The company’s overall ESG score is then calculated using a weighted average. Finally, next to data points, extra-financial research providers also develop tools to assess the negative news companies are getting involved into (i.e. “ESG controversy” screenings) or exposures to specific activities or sectors (i.e. “Controversial Activities” screenings).

Let’s illustrate this with a concrete example. The below mentioned example explains the set-up of an ESG scoring model for a company that is specialised in packaged foods:

According to the independent ESG provider, the main challenges for the economic sector of packaged foods relate to social issues (40% of the total score), environmental issues (35% of the total score) and finally governance issues (25% of the total score).

The three dimensions are assessed according to 4 types of indicators:

1. Preparedness indicators i.e. all policies and programs the company has adopted to manage the social risks a.o. social policies regarding the supply chain, regarding labour rights such as freedom of association, discrimination and diversity programmes or policy regarding product health which is a concern in the consumption industry.

2. Disclosure indicators i.e. all indicators the company may set up regarding the social issues. This is more relevant in the environmental area.


3. Quantitative performance indicators: the company can define a couple of quantitative indicators to assess the impact of its policies a.o. the percentage of workforce covered by collective bargaining agreements, the employee turnover rate to assess the company’s ability to keep talented workforce, etc.

4. Qualitative performance indicators: these are the reality check controls i.e. the company may have adopted clear and ambitious policies regarding labour rights in its supply chain whilst it is facing important scandals and issues related to violation of fundamental rights in one of its suppliers. If it is the case, the implementation and impact of formal policies and programs may be disputable.

For the three main dimensions, namely Environment, Social and Governance issues, a number of indicators is defined on which the company will be scored depending on the quality and effectiveness of its actions. According to the weight granted to the indicator, a weighted score is defined, which will make part of the total ESG score of the issuer.

Example of external ESG score (partial assessment)

Packaged Food Company – ESG average score 83/100

Soci

al

40%

Raw score

Weight Weighted score

Preparedness indicators Freedom of association policy 100 2.36% 2.4 Discrimination policy 100 1.36% 1.4 Supply chain management 50 4.36% 2.2 Quantitative performance indicators Employee turnover rate 0 2.36% 0.0 Fair trade products 0 3.36% 0.0 Qualitative performance indicators Employee incidents 80 5% 4.0 Supply chain incidents 100 4% 4.0 Consumer incidents 80 2.99% 2.4

Envi

ronm

ent

35%

Preparedness indicators Environmental Policy 100 0.85% 0.8 Water management programmes 50 1.7% 0.8 Sustainable agriculture programmes 100 2.13% 2.1 Disclosure indicators Scope of greenhouse gas reporting 100 0.43% 0.4 Quantitative performance indicators Water intensity 25 2.13% 0.5 Carbon intensity trend 75 0.43% 0.3 Renewable energy use 0 0.43% 0.0

Gov

er-

nanc

e 25

% Preparedness indicators

Bribery & corruption policy 100 0.5% 0.5 ESG performance targets 100 1% 1.0 Board independence 70 1% 0.7 Lobbying and political expenses 0 0.75% 0.0

Source: Sustainalytics, DPAM

Sustainability labels can be useful

Rather than looking directly into ESG data, investors can also look for the presence of a sustainability label. Sustainability labels are designed to provide transparency to clients and prospects over the ESG quality of investment strategies. They attest that a strategy matches several minimum sustainability criteria. Doing so, sustainability labels help clients and prospects identifying the funds and strategies which are truly taking into account the ESG dimension, in contrast with mainstream strategies which only marginally take into account ESG aspects. In other words, sustainability labels help investors dismissing “Greenwashing” strategies.


In more detail, sustainability labels commonly look at first into the quality of the sustainable investment process. They review which sustainability approach has been used (see the seven recognized core Sustainable investment approaches recognized by Eurosif in the table above) and how far they are implemented into the strategy. Sustainability labels are also increasingly looking into the portfolio’s holdings, so as to ensure that it effectively displays a sufficient level of ESG quality.

As a matter of fact, sustainability labels are an “all European affair”. There is virtually no significant sustainability label in the other significant markets for sustainable finance (i.e. North-America, Australia & New-Zealand, Japan and Asia). In Europe alone, about a dozen sustainability labels exist. These labels come with different requirements, which may reflect different priorities or concerns. For instance, Nuclear Energy is a sensitive issue in German-speaking countries whilst securities lending or use of derivatives are more of a concern in France. So, prior to choosing the sustainability label you will require, it is important to first compare the criteria of the assessment with your own objectives.

On the short to mid-term, a European label should help bring further clarity into the European market for sustainable strategies. Indeed, the future EU label for green financial products is one of the key proposals constituting the European Commission’s action plan on sustainable finance2. That being said, it is not yet released and its precise content remains unknown. Until then, investors still need to rely on the existing sustainability labels.

The first SRI label to be launched was the Novethic SRI label. It was started in France in 2009 and since 2016 it is replaced by the official “French SRI label” (a label supported by the French Ministry of Finance). With more than 300 funds labelled from more than 40 asset managers, the Novethic SRI label and now the French SRI label are among the most widely awarded labels. These are generalist labels, as they take into account the Environmental, Social and Corporate Governance dimensions.

Beyond the French market, the Luxflag ESG label is an interesting alternative, as it was designed as European ESG Label from its inception in May 2014. It has every advantages of a robust generalist sustainability label.

2 https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en

Did you know?

All DPAM sustainable strategies have obtained the Luxflag ESG label.


The FNG label is another example of a generalist SRI label. Launched in 2015, it is the label of reference for German-speaking countries (Germany, Switzerland, and Austria). One of its particularities is that it rates the funds from zero to three stars, depending on the quality and transparency of its sustainable research- and investment approach.

Similarly, the Morningstar Sustainability Rating also rates sustainability funds. The Morningstar Sustainability Rating is not a sustainable label per se, as any investment fund, whatever it claims to be sustainable or not, is screened. However, it still helps estimating the ESG quality of sustainability funds. In practice, funds are rated on a scale from zero to five globes, based on ESG scores of the companies and countries the portfolio is invested in (ESG scores are provided by the ESG rating agency Sustainalytics).

Next to generalist labels, investors can encounter specialized Sustainability labels. Thus, Green funds labels target specifically the Environmental dimension. They usually require investment strategies to report on the level of environmental performance of portfolios (typically in terms of carbon emissions, energy-intensity, water-intensity, etc.). Under this category can be found the Luxflag Environment label from Luxemburg, the Novethic Green Fund label, the French public Ecological and Energy Transition for the Climate label (EETC label), and the Austrian “Umweltzeichen” Ecolabel. With respect to the social dimension, the label Finansol in France and the Luxflag microfinance label are more relevant for “impact investing” funds. More recently, some labels are being created to guide investors through the emerging Green bonds market (e.g. the Luxflag Green Bond label).

All in all, sustainability labels are a useful instrument to help investors identifying the investment strategies which truly integrate ESG aspects into their investment process and their portfolios. All sustainability labels mentioned here are imposing strict eligibility criteria. Hence, prior to selecting a sustainability label, it is important that the investor reviews these eligibility criteria in the light of its own extra-financial investment objectives.

Focus on Luxflag ESG label

In order to obtain a Luxflag ESG label, a fund must:

describe its ESG strategy and criteria demonstrate how it integrates its ESG strategy and criteria throughout the investment process, and

notably: define its non-financial objectives indicate how it collects ESG research describe which sustainability screenings it uses and details how they are used present how investment decisions are taken (committees, role of portfolio managers) outline how the continuous monitoring of the portfolio is performed detail its divestment procedures

screen 100% of its portfolio using one or several ESG strategies and standards (i.e. the Eurosif Sustainable investment approaches, mentioned above in this document)

apply an exclusion policy (i.e. divest from one or several controversial activities and / or divest from controversial companies or countries)

publish its full portfolio at least once per year and be transparent towards investors

Moreover, Luxflag has set-up a dedicated ESG label eligibility committee which systematically reviews all applications to the ESG label, and frequently requires additional disclosure, notably about portfolios holdings.

Furthermore, Luxflag hires audit firms to verify the information provided by the applicants to the Luxflag ESG label.

The LuxFLAG label is valid for a period of one year. Labeled strategies must re-apply prior to the expiration. The renewal process includes a list of changes to the strategy, confirmation that, over the past year, all positions of the strategy were in compliance with the ESG criteria of the strategy, evidence of screenings, etc.

Source: Luxflag


How to assess your portfolio: in practice

The portfolio ESG score

A first commonly applied metric to say something about the overall sustainability level of a portfolio, is to look at the portfolio’s overall ESG score. This figure represents a weighted average of the ESG scores of the companies in the portfolio. As explained in the previous paragraph, ESG scores aim to summarize the sustainability performance of a company by looking at a wide set of different indicators related to environmental, social and governance themes. These indicators assess the quality of the sustainability related policies, programs and reporting that a company has in place, but they also integrate the effective performance by looking at various quantitative and qualitative indicators.

There are several reasons why a portfolio level ESG score is commonly included in a sustainability assessment. The first one is the ease of the metric. As it is backed by the expertise of specialized parties, it is easy to simply look at their final summarized score Without having to do a thorough and overall ESG analysis on every company in the portfolio. Meanwhile, a simple aggregate score makes it easy to make comparisons across different funds, especially when sustainability considerations are just one of the many indicators that are used to make a selection. For investors that are willing to assess the sustainability profile of a portfolio in a more substantiated way, the overall ESG score comes with some attention points.

As the below figure shows, the weighted average portfolio ESG score depends on a wide set of underlying values. On a first level, it aggregates the ESG scores of all the different companies in the portfolio. On a second level, the ESG scores of these companies depend on their performance on the environmental, social and governance pillars which assess different themes. Within these pillars, each company has been assessed on a wide set of indicators that are dependent on their sector and that carry different weights according to their materiality. The result is that the portfolio level ESG score is not able to give you a lot of information on why exactly a portfolio is sustainable or not. You could say that the score of one portfolio is higher than the other one, but you can’t say something about the underlying reasons. Meanwhile, as the score aggregates many indicators across different levels, it might conceal important deficiencies on certain more specific indicators. Therefore, a portfolio level ESG score can be used to grasp a first insight about the sustainability level of a portfolio, but to arrive at a robust assessment, the portfolio should be analyzed from additional angles.


Weighted average ESG score of a portfolio: the devil is in the details

Source: DPAM©

On a first level, the portfolio’s ESG score aggregates the ESG scores of all companies in the portfolio. As a portfolio usually includes a high number of different companies, any low ESG scores from companies that are lagging behind, will be embellished by high ESG scores from other companies. As a result, as indicated by the below figure, a portfolio with an ESG score of 70/100 might be invested exclusively in companies with an ESG rating around that same figure, which would be deemed positive, but might as well be invested in some of the worst scoring companies. The portfolio level ESG score will not reveal this information.

Weighted average ESG score could hide the extremes

Source : DPAM©


The distribution of ESG scores

To unveil the outliers, a simple solution would be to look at the distribution of the ESG scores of the companies in the portfolio. While active investment funds will not regularly report on all individual positions, a possible approach is to define buckets which group a certain range of ESG scores, and to report on the percentage of assets in the portfolio that falls within each bucket. For example, a scoring system with scores between 0 and 100 could be broken down in 5 scoring buckets: (1) scores between 0 and 20, (2) scores between 20 and 40, (3) scores between 40 and 60, (4) scores between 60 and 80, and (5) scores between 80 and 100. When visualizing this, it becomes easy to see that an elevated overall portfolio ESG score doesn’t necessary guarantee you a portfolio with a high sustainability quality across its investments. The below figure summarizes the distribution of the ESG scores of the companies in three different investment portfolios. While each portfolio has an average ESG score of 70, the last portfolio includes a high percentage of companies that are clearly lagging behind their peers.

The distribution of ESG scores: how really sustainable your portfolio is

Source: DPAM©

The equal importance of the three sustainability dimensions

Next to assessing in more detail the distribution of the underlying ESG scores, another interesting analysis is to look at the performance of the portfolio on the individual Environmental, Social and Governance pillars of the scoring models. For example, criteria that are linked to sound corporate governance are important to assess for every kind of company, hence a notable weak score on the governance pillar can reveal potential problems in terms of future corporate behavior. Widening the scope of the assessment to the individual E, S and G pillars enables to take this information into account. For the same reasons as discussed above, narrowing down the scores to different performance categories can help to reveal any outliers.


Holistic approach: the E, S and G dimension are relevant

Source: DPAM©

To deal with differences in practices and risks across business activities, most ESG data providers have developed distinct ESG scoring models for a wide set of peer groups and sectors. While this approach ensures a more tailored assessment, it has the disadvantage that it makes the final ESG scores less comparable across sectors. For example, if one industry faces heavy regulation or public scrutiny, the ESG scores of the companies within this sector may be naturally higher since these companies are obliged to take more measures. As a result, the average ESG score of this industry will not be 50/100 as one would expect from a mathematical point of view. It means as well that aggregating the averages of different industries can create a bias in the overall portfolio ESG score as a result of a big over- or underweight in a certain sector. Meanwhile, from an investor point of view, having more granular sector data can help to assess sectors for which the exposure to potential risks is more severe, such as environmental issues for the mining and the oil & gas sector and product safety issues for health care companies. Therefore, next to assessing ESG scores on the portfolio level, it might also be relevant to assess the ESG scores and the underlying E, S, and G pillars on the sector level. This gives an insight in how well sector-related risks are integrated in the investment process, but it also helps to better measure the exposure to certain sector-specific risks. Especially when a portfolio has a considerable active allocation towards a certain sector when compared with the reference universe, a solid sustainable investment process should equally attribute more attention to that industry from a sustainability point of view.

The sector impact on average ESG

Source: DPAM, Sustainalytics

All in all, ESG scores remain useful as they give a general overview of a portfolio. But there are also other dimensions that can be assessed.


Going beyond ESG scores: protecting the reputation of investments

The above section outlined the different interesting sustainability angles that can be retrieved from ESG scoring models. Another important dimension is to check the portfolio’s compliance with your minimum norms. You might want to enforce these because they include important reputational risks for your company, but metrics that are linked to minimum norms often also have their say from a performance point of view. Indeed, when companies are incurred in serious allegations, this might signal something about whether they are effectively managing their company’s risks. Meanwhile, not complying with certain international norms might lead to costly financial sanctions.

The best known example to check a company’s implication in severe misbehaviour is to assess its compliance with the 10 principles of the United Nation’s Global Compact. The UN Global Compact aims to defend the minimum human and labour rights, and fight environmental damage and corruption. While it provides mainly a framework, there are various extra financial research providers that are specialized in assessing companies vis-à-vis these norms. Whenever a company is found to be implicated in serious activities that can be linked to one of the four pillars of the UN Global Compact, these companies will carry a “non-compliant” label. When there is evidence of serious allegations for which the research findings are not yet entirely clear, a company might be labelled as being part of the “watchlist”. Assessing the portfolio’s exposure to both “non-compliant” and “watchlist” companies, can help to say something about the exposure of the portfolio to future reputational and financial risks. If the portfolio is built on a solid sustainable investment process, the investor should be able to defend its choice to invest in these kind of companies by reporting in a transparent way about the results of its internal analysis.

The Ten Principles of the UN Global Compact

Source: UN Global Compact

A second possibility is to assess the portfolio’s exposure to certain sectors or activities that you would like to avoid (often referred to as “Controversial Activities”). To do this, it is important to clearly set the exposure thresholds that define as of which moment a company is considered to be involved in a controversial activity. This is important as many global businesses are diversified and consequently have small exposures to many activities. A possibility is to define the maximum percentage of revenue or output that can be linked to each controversial activity. The exclusion of Tobacco provides a good example. Would it make sense excluding altogether producers of tobacco (who are the ones responsible for the use of harmful ingredients in the products, and for its advertising) as well retailers and distributors who are often selling Tobacco alongside many other products and to whom Tobacco represents a negligible share of their revenues? From a pragmatic point of view, it makes sense setting up differentiated exclusion thresholds for producers (who are considered the first responsible) on the one hand, and for retailers and distributors on the other hand. In practice, the fund management industry commonly sets exclusion thresholds in a way to effectively divest from the problematic companies without excluding the more marginally-exposed ones (for instance Carrefour).


Besides being exposed to certain sectors or being implicated in violations of global norms (e.g. the United Nations Global Compact), another important dimension of a portfolio’s ESG quality is its exposure to companies that are involved in ESG controversies and scandals. Companies’ exposures to ESG controversies reflect their corporate behaviour and the quality of their interactions with their stakeholders (e.g. their employees, local communities, NGOs, or the society at large). A recent example is Vale S.A., which had been involved in a first catastrophic dam failure in Brazil in 2015. The safety measures taken following the initial disaster had been deemed insufficient by several stakeholders for which the company was categorized by one of the extra financial research providers in one of the highest controversy levels. Sadly, a second large disaster occurred in 2019, confirming both the reputational and financial risk as the new disaster is linked to one of the biggest iron ore mines in the world, seriously impacting the company’s income.

A common way to assess a portfolio’s exposure to controversial news and activities is to divide companies in different categories according to the severity and recurrence of any existing events. For example, when a company keeps being exposed to controversies that relate to the same topic, like the safety of its products, extra financial research providers will categorize it in a more severe category than another company which only saw such an event occurring once. The impact of an event can also have it say in the categorization process. For example, when a company has been found guilty by an official institution, or when there have been serious fatalities, risks are bigger that is will be confronted with fines or penalties. Finally, also the reaction of a company is important. A company that doesn’t implement anything to prevent similar events in the future will have a larger exposure to potential new problems. When the breakdown of a portfolio shows that there is an increased exposure to companies that are classified in the more severe categories, you might want to assess the investment process in more detail to be sure that the linked risks have been thoroughly assessed and/or mitigated.

The importance of materiality: ESG integration throughout the investment process

When analysing a portfolio, you should as well distinguish among those ESG criteria for which there is a clear link with the financial performance of the companies (i.e. the material ESG criteria), from those ESG criteria for which the link with financial performance is less obvious (i.e. the non-material ESG criteria). Indeed, we often observe that the ESG factors which are material for the valuation of a company are sometimes diluted in the calculation of overall ESG scores. Sustainability models include a wide range of criteria but some of them might require a more in-depth assessment.

To account for material sector issues, a sound sustainable investment process should rely both on financial and sustainability analysts and let them work together. This is called ESG integration: ESG criteria should be integrated in the broader fundamental assessment of a company. As some ESG-related themes have an important link with the current or future performance of a company, the analyst that is specialized in assessing the financial situation of a company should be aware of them. For example, in the automotive industry, the electrification of cars will require tremendous future investments from those that want to take the lead, while those that are lagging behind risk to be too late in offering new solutions which will impact their future revenue. Therefore, it is recommended to integrate all different criteria into one assessment instead of assessing different types of criteria independently.

Linked to the integration of ESG criteria in the bottom up analysis of companies, it can be assessed whether ESG criteria are used throughout all the different steps of the investment process. For example, some portfolios will only use ESG criteria to define the eligible investment universe. They might apply some exclusions or some best-in-class filters to define the list of companies in which a portfolio manager can invest. While these filters can be effective to filter out the worst positioned companies, they primarily focus on the negative side and fail to take into account any ESG-related opportunities. For example, sustainability related criteria can also have their say in the selection of the themes that are interesting from a financial point of view. Think about the new European regulations regarding the use of plastics and the linked opportunities for recycling companies. Meanwhile, as will be explained in more detail below, some portfolios might have an additional target to invest as much as possible in companies that directly develop solutions for the world’s most important sustainability challenges. Therefore, next to looking at high level scores and filters only, also the investment process itself should be assessed as the differences between applying static filters and integrating data across the investment functions can be quite material for the final result.


Looking for impact

As a last step in the sustainability assessment of a portfolio, you might want to look beyond the sustainability programs of a company and focus solely on the sustainable impact of its products and services. While more and more companies are starting to publicly disclose information about their sustainability policies and practices, experience shows that corporate communication often outpaces the actual sustainability efforts that are delivered by companies. This is generally denounced as corporate “Greenwashing”. To avoid being excessively influenced by corporate communication (we call this the “the disclosure bias”), it is recommended to look as well at the actual achievements made by companies with regard to sustainability. For example, a company might publish fantastic targets to fight the air emissions of its production process, but is it also on track to achieve these targets and did it achieve any previous ones? ESG research providers increasingly include this kind of metrics in their models, but as all targets and programs are slightly different, it remains a challenge to assess actual achievements against what should be expected as a minimum, or against what has been done in the meantime by the company’s peers.

Next to assessing the credibility of a company’s programs, the assessment can also include impact considerations by going beyond the company’s sustainable operating model. Increasingly, it is important to look as well at the products and services that a company supplies, i.e. the very nature of its activity. For instance, while an oil company can do a lot to run its activities in a more sustainable way, it will still be extracting and transforming oil, thereby harming the climate. Meanwhile, a company that is specialized in recycling services might be publishing less information about its sustainability programs, but its business is sustainable by essence and ultimately it will have a better contribution to the sustainability challenges of the future.

Identifying the companies that have a sustainable impact through their products and services is not always that easy. For example, with respect to climate change, an investor might be sceptical about an investment portfolio which is actively positioned towards power utility companies. Often, power utility companies are indeed exposed to fossil fuels that are harmful for the climate. However, at the same time, some power utility companies are the key pioneers in terms of renewable energy. To be able to identify that, a portfolio’s reporting should go further than simply disclosing the sector distribution.

A popular framework that is increasingly used by companies and investors to link their activities and investments to impact themes is the United Nations’ framework of the Sustainable Development Goals (SDGs). The SDGs represent the 17 key goals that should be achieved by 2030 by the member countries of the United Nations in order to create a sustainable future for our planet. Even if the goals group targeted achievements for countries, business worldwide have embraced them to report on their sustainability initiatives.

The 17 UN Sustainable Development Goals

Source: UN SDG


From an investor point of view, the SDGs can be used as a framework to identify companies that are making a impactful contribution with their products and services. While it is not possible to directly invest in each of the SDGs (for example SDG 17: “Partnerships for the goals”), many of them can be linked to certain investment themes. For example, SDG 7 “Affordable and clean energy” can be linked to renewable energy producers or firms that contribute to innovations in the field of electric cars, and SDG 12 “Responsible consumption and production” can be linked to firms that are specialized in waste management. All in all, while a company can do a lot of efforts to organize its business practices in a more sustainable way, some companies will be contributing more by the very nature of their business model which is not always taken into account.


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