At Genuine Impact, we always try to stay on top of the most recent trends and developments in the financial and investment world - one of them being ESG investing.
With governmental regulations as well as company adaptations, there is a lot of talk around this topic. But how can ESG scores actually be measured? What frameworks are being used for that and is it even possible to generalise it all? With our ‘How can ESG create value’ series, we aim to de-mystify the concept of ESG, and to share insights and provide direction to investors on ESG considerations.
In 2009, a simple framework to analyse ESG issues with respect to impact in investment decisions was proposed in a white paper published by AQR Capital Management. In essence, this framework allows ESG considerations to be disentangled and classified into either "ESG Beta" (Systematic) or "ESG Alpha" (Company specific), thus providing a clearer direction to analyse ESG policies in the context or portfolio design and investment selection.
ESG beta is the “passive return” from systematic ESG improvement in the economy, which are predominately derived from change in consumer behaviour, social attitudes, regulation, or even through the cumulative impact of investors’ influence on companies and the allocation of capital. Investor can get exposure to ESG beta by simply owning a diversified portfolio of ESG compliant assets.
On the other hand, the concept of ESG alpha is similar to the traditional definition of alpha, i.e. seeking company specific advancements of underlying companies, in particular around the aspect of how ESG compliance create and improve shareholder value. There are several industry standard measurement of ESG performance which can be used for relevant investment analysis.
ESG rating of Microsoft, Feb 2022, Genuine Impact App
One important difference between ESG Alpha/ Beta and their traditional counterparts is the existence of a feedback mechanism between them. For instance, accumulation of individual companies making ESG-focussed management decisions (ESG Alpha) will lead to maturity of government regulations whilst investors who seek greater ESG alpha will also direct capital allocation towards more efficient ESG companies, thus influencing the behaviours of company’s management, therefore collectively establishing a positive feedback loop for the economy as a whole to become more ESG compliant (ESG Beta).
Overall, ESG considerations are mandated by society’s increasing demand for environmental, social and governance responsibilities. For companies to become ESG compliant it would mean for them to realign their behaviour to the requirements of future generations. As the society’s demand for ESG increases, so will each company’s need to realign their business objectives with changes in consumer behaviour and demand. Therefore, the quicker and more efficiently companies can adapt to these ESG demands, the more competitive they will likely be in the future, which in turn will create greater value for its shareholders.