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Brain Circuits

Putting the ‘G’ in ESG (and the ‘A’ in alpha)

Published 7 October 2024 in Brain Circuits • 3 min read

The governance aspect of ESG is a fundamental driver of environmental and social quality, but identifying companies characterized by good governance is a hard trick to pull off. Take this simple quiz to see if you know your ‘G’ from your ‘Oh gee!’

1. What’s the best way to understand a firm’s ESG position?

A. Using its ESG disclosures.

B. Using third-party ESG ratings.

C. Conducting bottom-up research on the company.

 

Answer: (C).

(A) is not a good way to obtain information, because such documents are not legally binding, non-standardized, hard to verify, and often incomplete. (B) does not lead to quality ESG insights, either. Such ratings are often contradictory, require great effort from investment managers to interpret, and do not lead to consistent and significant alpha. By contrast, (C) leads to a first-hand understanding of a company’s ESG position, providing the necessary insights for investment, monitoring, and active engagement.

 

2. Many investment firms struggle to use ESG analysis to generate alpha in their investment decisions. Why?

A. It’s difficult to distinguish between firms that merely provide ESG disclosure and others that truly practice what they preach.

B. Assigning a monetary value to ESG issues is computationally difficult.

C. The traditional methodology used tends to focus on the output rather than on the driver.

 

Answer: All of the above.

Boutique investment firms typically do not have the resources to cover a sufficient number of companies for effective diversification, while assigning a monetary value to ESG issues yields questionable results. And focusing on the output rather than the driver risks capturing a status rather than a dynamic: a firm may have a low carbon footprint simply because of its business model, rather than the active will of the board.

 

3. What’s the optimum way to approach governance from an investment point of view?

A. From a technical and mechanical perspective, using hard criteria such as number of independent directors, and size and diversity of board and management.

B. By understanding firms’ compensation and ownership structures.

C. By understanding what governance actually is.

 

Answer: (C).

Put simply, governance is the art and structure of decision-making at the top. Assessing it using hard criteria and metrics relating to firms’ compensation and ownership structures risks juxtaposing the three different dimensions of ESG as if there is a tension between them. Good governance drives the long-term orientation, values, and quality of an organization’s resilience and agility in environmental matters as well as in social matters.

 

Key takeaway

True G drives E and S

The catalyst for a good ESG policy starts with the governance which, in addition to triggering stock outperformance, enhances impactful and transformative environmental and social policies at the corporate level.

 

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