In 2022, we saw a rise in headlines questioning the role and effectiveness of ESG integration or investing, and in the use of third-party ESG ratings or ESG data. In many ways these headlines demonstrate the mainstreaming of ESG, and open the door to healthy and constructive debate around the challenges and limitations of responsible investment approaches, such as poor data quality, low data coverage, or insufficient disclosures.

However, in many cases, the headlines highlight the confusion and misunderstanding that exists around what different responsible investment terms mean. This is understandable, as the lack of consistent definitions and terminology is one of those challenges that needs to be addressed. A good place to start is by going back to the basics.

Defining the letters ESG is generally the easy part – it stands for environmental, social, and governance. What is more challenging, however, is sorting through the different ways the term ESG is interpreted and applied.

There is no one standard set of definitions, but at RBC GAM we refer to industry or regulatory standards wherever possible. One common misconception is confusing ESG integration with socially responsible investing (SRI), both of which may also be referred to as ESG investing, sustainable investing, or impact investing. Another aspect has to do with references to ESG data that are in fact referring to ESG ratings or scores from third-party research providers. We will walk through each of these in turn.

ESG integration vs. investing with an ESG objective

Let’s start with ESG integration, which is the process by which material ESG factors—or ESG factors the investor believes have the potential to impact price, valuation, creditworthiness, or other financial metrics relevant to the investment—are considered by investment managers alongside other financial information in order to inform investment decision-making.

ESG integration is based on a belief that considering material ESG factors may enhance long-term, risk adjusted returns, and that doing so is part of an asset manager’s fiduciary duty. For example, we believe that, in the long run, a well-governed company that is managing environmental risks and liabilities while treating its employees and community with consideration and respect, is in a better position to outperform peers that fail to do so. In essence, ESG integration is about making better investment decisions by considering ESG factors that may be material to a company’s performance. It is about maximizing risk-adjusted returns for investors.

Where the misunderstanding often lies is in mistaking ESG integration with investing with a specific ESG-related objective; which is often also done to align investments with investor values, rather than solely to maximize risk-adjusted returns. To add to the confusion, investing with an ESG-related objective may be referred to as SRI, sustainable investing, ESG investing, or impact investing. In this case, although the strategy may have a financial objective, investments are also being managed with the purpose of achieving a (typically) environmental or social objective, which may involve excluding companies from certain industries or activities (e.g. tobacco, thermal coal), or only investing in companies that meet particular criteria (e.g. low carbon emissions, women owned). Although investors may choose to have their assets managed using an ESG integration approach or managed with a specific ESG objective, these are distinctive concepts that are often confused in the common lexicon.

Terminology matters because it is only from a shared understanding of definitions that we can have thoughtful discussions, address challenges and derive solutions that meet investors’ needs. Although regulators in Canada, the U.S., Europe, and the United Kingdom, as well as international standard-setting bodies, are working to establish a common dictionary for ESG, these are not globally standardized. What this means is that as investors, we must be clear, transparent and precise in the language that we use, and carefully consider the language that others are using when referring to ESG.

ESG data vs. ESG ratings

Another set of terms that have been used interchangeably while referring to quite different concepts is ESG data and ESG ratings. Although both refer to information about a company’s performance on ESG issues, the information they are referring to and how it is used is actually quite different.

ESG ratings (or scores) are an aggregate view of an issuer’s performance on E, S, and G factors, based on one provider’s views. At the most concise level, providers seek to provide one value that reflects a combined view of the issuer’s overall ESG performance. This is often in the form of an issuer-level overall ESG rating or score.

By their design, ESG ratings depend on the methodology used by the third-party data provider that generates the rating, and are intended to provide its proprietary view on ESG performance, including its proprietary view on the materiality of individual ESG factors. This also helps explain why there is generally a lack of correlation between ESG ratings from different vendors – they each use different underlying ESG data factors, different weightings for those factors, and different methodologies to create their score or rating.

This in and of itself isn’t an issue, as long as investors recognize ESG ratings as only one input or one opinion that may inform investment decision making and not as a definitive “truth” on ESG performance. In fact, this is similar in concept to sell-side analysts providing different earnings forecasts for a company: each of these should be assessed on its merits and taken as input versus fact. It is for this reason that RBC GAM subscribes to ESG ratings from multiple providers. In addition, investment teams may leverage ESG data, research and due diligence, engagement, and other inputs to inform their view of material ESG factors and performance.

Although ESG ratings aim to combine ESG performance into a single value, ESG data refers to the many individual data points related to ESG issues. ESG is complex, and for any one company the E, S, and G factors can be intertwined, with each one influencing or impacting the others in ways that are often difficult to separate. As a result, the importance of each of these factors in an investment decision will vary for each issuer, which is why the focus on materiality is critical. For example, carbon emissions may be material to an energy company but less so for a health care company. Tailings and water management is material to a mining company but less so for a professional services company. It is for this reason that it is often important to go beyond ESG ratings and look at the underlying ESG data for a company.

ESG data may be:

• quantitative data regarding the percentage of board members that are women
• a more qualitative assessment of the quality of risk management and types of policies at a company
• sourced directly from companies (i.e., reported data)
• or either estimated or modelled. It may also include time series or historical data as well as projected forward-looking data.

At RBC GAM, our investment teams have direct access to in-depth and multifaceted ESG data. Each investment team or analyst may then select and use specific ESG data factors that they believe are material to a company, sector, asset class, or geography.

Illustrative example of the difference between ESG data and an ESG rating

Where do we go from here?

Consistent and transparent use of ESG-related terminology is essential to advancing responsible investment. For RBC GAM, responsible investment (RI) is an umbrella term used to describe a broad range of approaches for incorporating ESG considerations into the investment process.

These approaches are not mutually exclusive; multiple approaches can be applied simultaneously within the investment process. For instance, a solution applying exclusionary criteria to the investment universe can also apply ESG integration to the remaining assets eligible for investment. Efforts are underway globally, and in different regions, to increase the consistency and standardization of both terminology and disclosures related to ESG.

For example, in 2021, the IFRS foundation established the ISSB, which is tasked with developing sustainability and climate disclosure standards at a global level. Regulators in several jurisdictions are also establishing, or planning to establish, product-labelling guidelines that aim to bring consistency and transparency to clients. To date, this includes new or proposed requirements in Europe, the U.K., Canada, and the U.S. As these initiatives move forward, it will be important for there to be alignment in terminology and core concepts, or they risk adding to the confusion, instead of solving for it.

At RBC GAM, RI includes the following investment strategies:

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