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The benefits of ESG integration

The rapid growth of macroeconomic trends, like the effects of climate change, changing technology and shifting demographics, are bringing us closer to the future that is quite different from the present. As the global economy and the social landscape change, these changes can create new risks and present new opportunities for investors over the next few years.

The evidence is growing to demonstrate that companies that address non-financial environmental and social governance (ESG) threats like work environment (including contemporary slavery) and climate change and who concentrate on good governance will also be more profitable over the long run.

One of the most comprehensive researches in this field, Deutsche Bank and the University of Hamburg examined more than 2,000 studies that were empirically related to ESG integration and financial performance. They concluded the following: ESG Integration did not negatively affect the return on investment in the majority of studied studies. And generally it was beneficial.

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

In addition, the difference in return between the most and least ESG-rated companies has increased in recent times, with it being at or near 2.9 percent over the last five years (2015 until 2019).

The demand of pension schemes for investment in companies with robust ESG profiles is growing rapidly. For this reason trustees as well as asset managers, consultants and advisors need to gain a better understanding of ESG aspects that can have the greatest impact on the financial results of a particular investment.

ESG integration is a way to do this. It 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 helps investors by identifying and addressing ESG risks, along with other financial data, to measure the goals of strategy, management and quality of firms. This all will affect the company’s performance and will be related to the return on equity.

The advantages of ESG integration can be described as follows:

* Improving the performance of corporates

The long-term financial advantage from ESG integration on a corporate level is that improved ESG practices can improve corporate financial performance and increase financial value.

* Strengthening long-term future investment returns

ESG data and metrics can help improve portfolio construction and the stock selection process. This can add long-term value, and reduce ESG risk.

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

The investment in companies with greater momentum ESG ratings is likely to witness greater improvement on their performance in the financials, which leads to better valuations and higher return on investment.

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

Actual examples show that ignoring the financial risks arising from ESG issues can have a significant impact on the performance of a business and negatively affect the value of shareholders.

These advantages mean that ESG aspects are likely to play a growing and clearly integrated part in determining the strategy for allocation of assets, portfolio construction and selection of managers. It will also be essential to support strategies’ long-term perspectives and complementing conventional financial analyses as a part of the investment decision-making process.