Materiality Check: The Next Stage of ESG and Responsible Investing

Environmental, social and governance (ESG) issues continue to raise big questions for investment firms and clients. We think the future will be defined by a focus on material issues and changing client needs.

Responsible investing has been on a pendulum. Enthusiasm for incorporating ESG issues in investment strategies has given way to a reality check in recent years. Investment firms and clients today face tough challenges, including regulation, research, politics, portfolio implementation and performance. But in our view, responsible investing—the incorporation of financially material ESG factors into investment practices—isn’t going away anytime soon.

As responsible investing evolves, the broad spectrum of client preferences and perspectives are at the heart of today’s ESG challenge. For us, the key question is: How can a global investment firm develop an ESG framework across asset classes that meets varied needs and enhances our ability to deliver the best possible outcomes for clients?

Fiduciary Responsibility Must Define ESG Efforts

The fiduciary principle of striving to achieve the best possible investment outcome for clients underpins every asset manager’s decisions. Yet when it comes to responsible investing, implementation of that fiduciary responsibility can take different forms. We think asset managers should offer a range of portfolios with different investing approaches to meet varying client needs.

But there should be a unifying principle to responsible investing efforts. We believe that grounding all these ESG approaches in materiality is the key to meeting an investment firm’s fiduciary obligation to clients. That is, a portfolio manager’s duty is to analyze issuers and securities based on an array of pecuniary factors that could materially affect risk and reward potential. ESG issues that may have a positive or negative material impact on a business and a security’s return must be part of that analysis. From our perspective, it’s simply good investing.

Many ESG issues create risks and opportunities for companies. For example, businesses using forced labor in supply chains could face an import ban in the US. Modern slavery poses business risks to industries as diverse as fishing and finance. Natural disasters such as hurricanes, earthquakes and droughts are becoming more numerous, extreme and costly for companies. Biodiversity is a potentially material issue amid the growing pressure on Earth’s life-sustaining and business-enabling resources and processes. The rapid rise of AI has unleashed a plethora of tricky ethical issues for companies, ranging from how much energy these efforts consume to the risk of model bias to the potential for job losses. Management behavior and other corporate governance practices can have a big influence on broader business outcomes. And we must acknowledge that material ESG risks and opportunities are often interconnected. In our view, researching issues like these as part of fundamental business analysis can enhance decision-making and client outcomes (Display). 

Detecting Meaningful Risks—and Opportunities

What do many of these ESG issues have in common? In most cases, regulation is increasing globally. Companies that run afoul of the rules could face reputational risk, penalties and sanctions, which may impede efforts to boost revenue and earnings and incur costs.

At the same time, proactive companies with solutions to ESG challenges can enjoy profitable opportunities. Examples include companies that help building infrastructure become more energy efficient, manufacturers of alternative energy equipment and companies that are enabling access to medicine or technology.

When ESG risks and opportunities are material, we believe it would be remiss for an investment manager not to consider them in fundamental research.

Implementation: Integration vs. Focus

There are, of course, many ways to apply a materiality approach in an investment process. Since the terminology isn’t standard across the industry, investment firms must help clients understand the differences, amid the confusion created by an explosion of ESG-related portfolios in recent years.

“ESG integration”—the approach described above—incorporates material ESG issues into research, engagement and security selection within a portfolio, using a traditionally defined investment universe. Integration is employed by most of AllianceBernstein’s (AB’s) actively managed investment strategies.

Some clients prefer what we call “ESG-focused portfolios”—those that define an investment universe based on specific ESG criteria, such as identifying companies that are transitioning to a low-carbon economy or companies with revenue aligned with the United Nations Sustainable Development Goals.

Both approaches share a common goal: to deliver attractive risk-adjusted returns for clients. The difference is that in ESG-focused portfolios, returns are generated using an ESG-related investment lens.

The Regulation Paradox: Transparency and Complexity

Regulatory efforts aim to provide greater clarity about ESG credentials of portfolios. For example, some traditional investment strategies now provide detailed and widely recognized ESG-related information about holdings and the portfolio. Although this doesn’t mean a portfolio is managed with an ESG focus, it provides transparency for investors who want it.

The EU’s Sustainable Finance Disclosure Regulation (SFDR) from 2021 aims to improve transparency about ESG features of investment portfolios by having firms classify them as Article 8 or Article 9 products. Under SFDR, Article 8 portfolios should promote “environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.” Article 9 portfolios should have “an objective of sustainable investments,” according to SFDR. These classifications leave much room for interpretation, yet they help investors identify portfolios that meet their preferences.

Different regulatory requirements have popped up in other jurisdictions, such as labelling regimes in the UK, France and Singapore. While the regulations may have similar goals of promoting transparency and addressing greenwashing, each framework differs in its scope or requirements, adding both a level of complexity and confusion. As a result, it’s challenging to do an apples-to-apples comparison between any two regulatory frameworks.

The last word has yet to be said. We believe that evolving regulation, client scrutiny and performance trends will ultimately lead to a shakeout of products that don’t meet certain expectations. Meanwhile, firms and portfolios that develop innovative ways to research material ESG issues and to deploy capital effectively to meet clients’ fiduciary needs will likely gain traction. 

Case Study: Climate Research and Implementation

As one of the most prominent ESG issues globally, climate change deserves special attention. It also provides a great example of how an investment firm can cater to diverse client needs while staying true to the materiality principle.

The first step is to create a comprehensive research framework. At AB, climate risk management is a top priority in our overall ESG research effort because we believe climate change presents acute material risks to companies. In recent years, we’ve built a climate transition alignment framework to help our investment teams identify transition risks and opportunities. This proprietary framework isn’t intended to be a mandatory route to net zero emissions, nor a way to assess transition risk through a single backward-looking metric, such as a carbon footprint. Instead, it helps us better understand companies’ unique paths for navigating a lower-carbon future.

Our climate research efforts also benefit from a partnership with the Columbia Climate School. Through this collaboration, investment teams gain access to academic expertise on the science of climate change and physical risks, which helps improve the analysis of sectors, industries and companies. Columbia gets to see the real-world application of its academic research, while our investment teams and clients can better educate themselves on crucial climate issues.

With data in hand, our portfolio managers and analysts can develop investment insights about a company’s long-term prospects. These insights also inform engagements with companies to see how they’re managing risks and to determine whether their businesses will be successful in a lower-carbon world.

How the research is applied depends on the portfolio’s philosophy and client preferences. For example, within traditional mandates, a portfolio could deploy an ESG-integration approach by incorporating knowledge of material risks and opportunities created by climate change in the full risk-reward analysis of holdings; insights from this research can also inform engagements with high-emitting companies. Alternatively, clients can choose a more specific climate focus, by setting portfolio decarbonization targets or investing in climate solutions.

Engagement Sharpens Investment Insight

For active investors, we believe that developing conviction in a company’s risk/reward profile also requires engagement with management—including on material ESG issues. This principle guided 1,703 ESG engagements that we conducted during 2023 with 1,296 unique issuers (Display). 

These engagements have two purposes: developing insight and encouraging action. Portfolio teams meet with management and board members to discuss impact, strategy and responses to material ESG issues. By doing so, they can develop in-house views on a company’s current ESG credentials, future direction and impact on an issuer’s financials or valuation.

Portfolio managers and analysts can also encourage issuers to improve business activities and responsibility practices to create shareholder value and reduce/limit credit risk. Since both engagement goals aim to enhance shareholder value or return potential, they support an investment manager’s fiduciary duty toward clients. In other words, targeted engagement efforts are also essential ingredients in good investing practices, in our view.

But what do clients expect from their investment managers when it comes to ESG? Questions about our corporate ESG practices are commonplace in communications with clients. We’re often asked about our firm’s ESG policies and research and investment processes in requests for proposals (Display). 

These questions indicate that ESG issues remain firmly on the global investing agenda. It also reinforces our belief that ESG won’t fizzle out like some investment fads of the past.

Shaping the Future 

Change will continue. Regulatory scrutiny, fund flows and performance patterns are all shaping the future of responsible investing. This is a natural evolutionary process that we’ve seen before, and the industry should emerge stronger. Asset managers that develop advanced technical tools to enhance the assessment of material ESG factors will be well placed to deliver better outcomes for clients.

Opponents of ESG aren’t going away either. Yet we think the public debate should be constructive, pushing the diverse spectrum of responsible investing practitioners to stay focused on our common objective: delivering strong risk-adjusted returns for clients. Some services may not survive, while those that do will likely be strategies that truly add value through better ESG integration and focus. Just as traditional investing tactics and processes have developed over time, we believe that the use of ESG in investment portfolios in the future will benefit from more consistency and transparency based on a thorough materiality check of research and portfolio processes.