How to embed ESG factors in your investment strategy

By Altin Kadareja, CEO of Cardo AI 

Although the inclusion of environmental, social, and governance factors has evolved into a distinct form of responsible investing, the concept of an ESG-compliant investment isn’t always clear. While it’s become more a case of “how” rather than “when”, the question of when it is appropriate to embed ESG factors in day-to-day investment activities remains. 

To determine what constitutes an ESG-compliant investment and how to approach it correctly investors can, fortunately, use a similar strategic approach to other forms of investment management. Essentially, it’s about defining goals, designing a strategy, measuring and monitoring success, and finding the right data to fine-tune the approach.

Identifying the goals 

As with other investments, the first step with ESG is to set meaningful targets for the investment strategy. Targets that will be somewhat different to usual investment targets – they’ll need to demonstrate a positive impact on the environment, society and governance of the investee. Quantifying these can be very challenging.

The first in a series of questions investors need to ask themselves is to define the main goals and objectives of the investment strategy and understand: “How can the ESG factors support and impact strategy and investment performance?”

An investment mandate’s targets embedded with ESG factors must be clear, measurable and time-dependent. For example, a private debt fund may set a target of cutting its carbon footprint by at least 50% by 2030 to outstrip the benchmark with an average of 30 basis points annually. 

Effective targets need not be limited to climate-related issues – they could also integrate other goals. For example, a fund may want to improve productivity and resource efficiency by 30% within four years by aligning no less than 75% of its investments with the UN’s Sustainable Development Goals 8 and 12.

A strategy based on data

Following the establishment of clear and measurable goals, the organisation needs to formulate a strategy for accomplishing them. A fundamental part of the strategy should be developing an ESG investment policy that assesses ESG factors across investment management’s life cycle. This includes sourcing, evaluation, structuring, investing, monitoring and exiting from deals.

Data availability is of strategic importance at this stage of the process. No matter how ambitious or resourceful, asset managers often fail to fulfill ESG policies because of the absence of data in the application and monitoring phases. 

Another element to consider at this stage is engaging borrowers and crafting ESG covenants. Both positive and negative covenants are helpful tools to use. For instance, positive covenants could be the application of dynamic pricing and an interest rate drop once ESG objectives are achieved. In contrast, negative covenants could be a decrease in funding limits or equity conversion for disregarding ESG factors. 

The last, equally important element to consider when crafting a strategy is to ensure a proper project management process. Internal ownership requires the team to take responsibility for direct activities and deliverables, defining external party management, and selecting tools that will support the strategy’s successful application. 

Performance monitoring

Applying the plans in practice will always be hampered by challenges, unexpected obstacles and grey areas. To absorb these, it’s necessary to review the plan regularly, with progress toward the objectives and compliance with the investment management agreement being the two most important factors to consider. 

The regularity of the review depends on the relationship with the borrowers, the specific target, and how difficult it is to reach it. Any agreement should have a monitoring plan, but organisations must also be flexible should circumstances change.  

Avoiding the risk of greenwashing

The misrepresentation of ESG progress to portray an organisation as doing more for good causes than in reality, or greenwashing, remains a significant risk for investors. However, asset managers can maintain an accurate representation of their ESG efforts in several ways.

One is to use an annual questionnaire or in-person meetings to determine the project’s alignment with the investor mandate. An alternative approach is to develop a framework that allows stakeholders to communicate transparently and challenge project assumptions, including requests for additional ESG data points to fulfill reporting requirements.  

Asset owners can also use monitoring tools to receive detailed investment data and ESG KPIs to confirm that the asset manager’s policy aligns with their requirements. These tools are handy because they allow asset owners to compare all asset managers in their portfolios quickly and easily.

The road ahead 

The demand for transparency on sustainable and socially responsible practices is rising. Both asset owners and asset managers are eager to put their money into organisations that positively impact the world, thereby aligning their investments with their own values and regulatory responsibilities. This trend requires that asset managers actively work on improving their ESG reporting strategies to avoid being accused of greenwashing. They must prove the increased availability of ESG data points. Those that fail to do so will fall behind, while those that follow a prudent approach to ESG reporting will have the pick of the crop.