ESG Integration in Investments: A Trend Set to Grow

The investment world has been undergoing some changes in recent years. One of these relates to concerns about ESG issues (an English acronym for Environmental, Social, and Governance topics). There has always been significant concern regarding governance when analyzing an investment. However, concerns related to pandemics, global warming, and reports of slave-like labor have brought environmental and social issues to the forefront.

****What is ESG integration in investments?

ESG integration is simply the incorporation of environmental, social, and governance factors into investment analysis and portfolio management.

Among the main issues taken into account are the following:

• Environmental: climate change, natural resource depletion, pollution, deforestation
• Social: human rights, modern slavery, child labor, working conditions
• Governance: bribery and corruption, executive compensation, board structure and diversity.

The ESG theme has two perspectives: risks and opportunities.

Risks often seem more obvious, as we frequently see asset prices affected almost instantaneously when some type of environmental accident occurs or a scandal involving precarious working conditions is revealed, for example.

Opportunities, on the other hand, can arise through:

• cost reduction, such as the more sustainable use of resources
• increased use of a particular material due to a shift in consumer habits towards more sustainable ones, such as the electrification of vehicles
• or through the emergence of new markets, such as carbon credits.

How to implement ESG integration?

ESG integration can be applied across various asset classes, such as equities, private credit, private equity, real estate, and infrastructure.

There is a significant challenge in integrating ESG aspects into investment decisions, as there is no standard methodology, meaning there isn't a "recipe" that suits all needs.

The simplest and longest-used method is negative screening, where the investor defines a list of sectors and companies in which they will never invest. Typically, these lists include controversial sectors, such as armaments and tobacco, and companies with governance issues, a history of fraud, and misconduct by their controlling shareholders.

Another approach would be the opposite of negative screening, which means investing in companies with the best ESG practices within their respective universes, also known as best-in-class.

One approach that has gained significant acceptance among managers is to integrate ESG aspects into the assumptions used for investment valuation. For example, an equity fund manager might include in their models the increased costs for a particular company due to water or energy scarcity impacting its operations, or the risk of fines in the event of an environmental accident. There is also the possibility that companies less attentive to ESG factors may face higher financing costs, leading to greater future financial expenses and, consequently, lower profits.

Furthermore, many investors use their equity positions in companies to engage them in adopting more sustainable practices, thereby creating long-term value for both their shareholders and society.

****Why Integrate ESG?

ESG integration can be driven by various factors.

From the client perspective, there is a growing demand for investments to align with their values and a requirement for greater transparency regarding how their money is being invested. Furthermore, we are experiencing a transition to a generation that tends to be more concerned with ESG issues.

From the managers' perspective, there was a notion that including ESG themes in investment selection was detrimental to returns and not part of their fiduciary duty. The truth, however, is that problems related to environmental, social, and governance issues have had very significant impacts on asset prices and, consequently, on fund returns. Two examples that demonstrated this were the 24.9% drop in Vale's stock price the day after the Brumadinho dam disaster and the 77.3% drop in Americanas' stock after the discovery of fraud in its balance sheet.

Another important point that leads investors to be concerned with ESG issues is regulatory matters. There is a global trend for governments to encourage or even require the analysis of ESG factors by companies and institutional investors. In Brazil, the CVM (Securities and Exchange Commission) issued a resolution obliging publicly traded companies listed on B3 to publish sustainability-related financial reports starting in 2026.

****ESG Integration: A Point of No Return

Investor interest in ESG has grown, and Jera understands the importance of environmental, social, and governance factors for long-term business returns. Therefore, we have included ESG factor analysis in our due diligence to monitor the risks and opportunities this trend can bring to our clients.