The power of sector-specific ESG analysis

This article appears in the June 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Over the years, responsible investing has evolved from a purely exclusionary practice to one that evaluates sector-specific risks.

This evolution has come as the market has rewarded companies for disclosing environmental, social and governance (ESG) data and as asset managers and investors have demanded tighter reporting standards — allowing portfolio managers to dig deeper when assessing companies.

But with this disclosure comes an explosion of ESG data. Forward-thinking managers, therefore, spend more time reviewing material ESG risks — ones that are most likely to affect a company’s financials.

“We’re looking for a company that focuses on the key issues affecting its sector,” said Rosalie Vendette, a sustainable finance expert with Decode ESG in Montreal.

Rather than excluding certain sectors altogether, some managers prefer to identify the best ESG performers relative to their peers and include those companies in their portfolios. But rating companies on sector-specific criteria can be challenging.

Sector-specific issues

The issues managers assess depend on the sector in which the company operates. Social issues, for example, are not assessed the same way for a bank as they are for a factory, where workers are exposed to greater risk from accidents. For banks, on the other hand, protecting client information is paramount, which is not likely the case for a factory.

“Certain sectors may be more prone to material ESG risks due to the nature of their business or operations. As a result, it’s important to consider best practices within a sector and an issuer’s relative performance against sector peers,” said Derek Butcher, senior ESG analyst, corporate governance and responsible investment with RBC Global Asset Management.

In health care, the focus is on the unmanaged social risks while ruling out firms with high controversy scores, said Christian Richard, partner, chief investment officer and portfolio manager at RGP Investments. For example, health-care companies must balance affordability for drugs and services with profit-making.

Simon Senécal, partner and portfolio manager, responsible investment at AlphaFixe Capital Inc., added that there are environmental concerns in health care as well: for example, medical equipment consumes a lot of energy.

In technology, the overall ESG risk rating should be low. “As it’s considered easier for these firms to disclose environmental data, those who’ve done their ESG legwork with recognized external organizations don’t go unnoticed. These initiatives show their commitment,” Richard said.

However, technology’s environmental impact is not small. For example, University of Cambridge research shows that Bitcoin activities consume about 138 terawatt hours of electricity annually — more than the entire country of Sweden.

But according to S&P Global’s ESG Industry Report Card for tech, the sector’s most relevant ESG risks are social, such as privacy and data security concerns, “because many technology companies collect, manage and monetize sensitive information for corporations and individuals that are at risk of misuse.”

How do portfolio managers navigate these complexities?

AlphaFixe Capital first compares companies to their peers and then assigns a score by weighting the criteria important to each industry. The environment, for instance, has a 50% weighting for automotive companies, but 60% for pipeline operators and 70% for power generators. “In these industries, a greater financial impact may be triggered by their behaviour toward the environment, which is why we overweight that factor,” said Senécal.

For the industrial sector, environment has a 50% weighting, but Senécal said that social risks have increased since the pandemic hit. Social now has a 20% weighting due to the risks of worker injuries and, lately, infection.

As a result, not every industry has the same starting point.

“These issues have everything to do with investors’ potential risk exposures, whether due to a company’s reputation or regulatory changes that would, for example, impose higher compliance costs on industry players, as with a carbon tax,” Senécal said.

While the differences are important, it’s worth noting that there are commonalities across sectors. These include the importance of sound corporate governance, climate change, employee management and transparency, Butcher said.

Persevering amid competing standards

Because issues vary from sector to sector, many firms keen on practising RI are interested in materiality — the relative weight of a given criterion for their sector. Help is available from a range of tools, including the Sustainable Accounting Standards Board’s (SASB) materiality map.

“The SASB has done collaborative work with businesses, business representatives and the financial sector to attempt to isolate, understand and identify the most significant issues for each sector and subsector. Criteria were identified for 77 [sectors],” Vendette said.

The standard, however, is voluntary. And businesses that wish to make disclosures are faced with numerous entities and frameworks, each with their own parameters.

This lack of consistency “harms the image” of sustainable investing, Vendette said.

While various bodies are working to create standards, “The SASB is the most credible system to use in the marketplace to date, so we’re building on that,” said Senécal. “However, the difficulty lies in the fact that there is often a range of criteria by industry, and data for some criteria is not regularly disclosed.”

The problem is particularly pronounced in the Canadian bond market, which includes a variety of private companies that report very little information.

Another example is financial institutions, which often provide scant detail about their loan portfolios. Sometimes they simply state their use of “energy” without specifying whether it is renewable or fossil fuels.

Portfolio management firms are looking for greater clarity using a variety of strategies.

“We encourage our investee companies, through both direct and collaborative engagement efforts, to enhance reporting on material ESG issues. We also engage directly with boards and management on material ESG issues to gain further insights into how issuers are addressing ESG related risks and opportunities, which can complement existing disclosures that may be limited,” Butcher said.

AlphaFixe has adopted a reporting rating system and often contacts companies of interest directly to secure desired information.

RGP Investments bases its analysis on other data sources as well. “We obviously depend on the ratings we’re able to source from suppliers, such as Sustainalytics, and whether they’ve integrated materiality into their assessments,” Richard said.

“However, we’ve assembled our own calculations by cross-analyzing the SASB materiality areas with the industries catalogued for each position we analyze. We can also gauge the validity of their ESG assessments using other external sources, depending on what we deem most relevant.”

Clearly, the commitments made by firms are not yet perfect, Senécal said, but it’s important not to wait for perfection — otherwise things will never change.