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How to add ESG factors to your portfolio? Positive/ Best-in-class screening

The best-in-class approach involves selecting top companies in terms of ESG metrics. These companies are actively making an effort to improve their ESG impact. Best-in-class screening rewards them by overweighting these companies in their portfolios. 

This method has the advantage of including companies that operate in industries that are not necessarily ESG-friendly. To illustrate, the energy sector is one of the worst sectors for sustainable investment due to its devastating effects on the environment. The energy sector represents 10.2% of the total nominal gross domestic product in Canada and represents over 12% of the S&P/TSX Composite Index as of March 31, 2021. Excluding this sector would mean a substantial deviation from the main Canadian market index. Positive screening also has the benefit of encouraging companies to adopt better ESG guidelines because that would make them more competitive compared to their peers. 

However, implementing a best-in-class screen is time-consuming, if done without the use of third party ESG ratings. Analysts must examine each company in the universe and rank them in terms of sustainability. Third party such as Sustainalytics, offered by InoAdvisor as an add-on, can considerably improve this tedious process. We provide a breakdown of the ESG Risk Rating, Notable Material ESG Issues, Product Involvement and a list of Controversies on over 12,000 companies worldwide. 

Implementation 

Best-in-class selection can be done on an absolute basis, when companies are selected based on their outperformance in terms of ESG characteristics in the entire universe, or on a relative basis, when companies are compared to their competitors within the same industry/sector and are selected based on their superior ESG ratings. 

We focus on the relative basis as it is the most used method. The steps are as follows: 

1. Assign an ESG rating to each company in the investible universe

Each company
has to be analyzed and assigned an ESG score in order to compare companies across sectors or industries and determine which ones are the best in terms of ESG performance. An alternative to this lengthy process is to use readily available ESG data providers.

2. Rank the stocks from best to worst in each sector

Classify the companies in each sector or indus
try from best ESG scored companies to worst ESG scored companies.

3. Overweight the ESG leaders and underweight the ESG losers in your portfolio

Depending on your strategy, you can overweight top ESG companies and underweight bottom ESG companies or only include top ESG companies in your po
rtfolio

Illustration 

Using the InoAdvisor’s screener, we find the best-in-class stocks in the Canadian energy sector. 

We apply the following filters to stocks listed on the TSX: 

  • Energy sector, 
  • Market capitalization of $1 billion or above, 
  • Current SP Score of 5or higher and, 
  • Positive Return on Capital. 

We get a list of 11 Canadian energy companies, ranked from lowest ESG risk exposure to highest ESG risk exposure. Portfolio Managers using the best-in-class approach will favor the lowest ESG risk exposed companies, which implies a higher ESG rating, to their portfolios. 

For a list of this screen, click here. Contact your account executive if you are not already subscribed to our new ESG add-on. 

Pembina Pipeline Corporation (PPLis the top company in our screen. Despite a high Overall Exposure Score of 44.3, the company’s ESG Risk Rating stands at 20.2. Iis able to considerably manage its ESG risk through its ESG measures. From their Sustainability Report 2020, Pembina 

  • Focuses on safe working conditions, with their safety records continuously exceeding the industry average, 
  • Is once again recognized as one of Canada’s Top 100 Employers, 
  • Advanced the implementation strategy for their Carbon Stand as well as their Inclusion and Diversity Stand, 
  • Demonstrated support to the communities in which they have a presence, with a direct investment of $10 million in 2019, a 30 percent increase over the prior year.

The Best-in-class ESG Integration technique helps investors align their values and enhance their risk-adjusted returnsUsing third-party ESG data improves the integration process by reducing the time and effort required to analyze how sustainable companies are. This method encourages companies to consider ESG issues in addition to their bottom-line because mindful investors favor ESG-friendly companies.