To manage sustainable investments well and deliver better outcomes for clients, investors need certain preconditions in place. We call them the ‘3 Ps’: philosophy, people and process.

From the start, we believe companies need to operate with a systemic conviction that investing sustainably leads to portfolio outperformance. That philosophy must cascade throughout a business – from research to investments to portfolio management.

Investment managers should integrate environmental, social and governance (ESG) factors into company analysis on the grounds that it leads to a more complete understanding of a business and the macroeconomic and thematic drivers it is subject to.

These vary vastly between industries and include topics such as energy transition, biodiversity, waste management and access to health care, which in turn can create tailwinds in areas such as capital allocation, technology and regulation. Conversely, if not well managed, such factors can impact costs and access to financing.

Understanding these ESG risks and opportunities enables investors to value a company’s securities more accurately and gain a greater understanding of how a portfolio may perform.

However, investors without this philosophy in place from the beginning will find it difficult to build a process that enables them to do sustainable investment consistently well.

The second ‘P’ is for people. This does not refer to individuals who tick an ESG box, but to building multi-disciplinary ESG expertise and diversity of skills and experience across a firm.

ESG experts should be embedded in investment teams across asset classes, as well as in other areas such as regulation and quantitative analysis. They should collaborate so that all inputs are fed back to make analysis more complete.

The third ‘P’ is for process – ensuring that appreciation of ESG risks and opportunities is fully integrated. This starts with fundamental company analysis. It’s analysts who research companies and they will benefit from incorporating ESG factors into their thinking.

Importantly, ESG analysis must be integrated from start to finish. The earlier that investors study how economies are evolving and which companies are in line to benefit, the sooner they can drive alpha generation.

Factor ESG in at the end of the investment process – where the focus tends to be more on downside protection and screening – and it’s too late to benefit from insights on how economies, markets and companies are evolving.

As an example, abrdn’s equity and fixed income teams are constructive on the outlook for India’s energy transition. India is the world’s third largest emitter of carbon dioxide after China and the US[1] and is shifting from an electricity grid driven by fossil fuels to renewables.

The question we ask ourselves is: can India continue to grow economically while reducing the carbon intensity of its economic activity at the same time? Our role as investors is to understand how companies manage these risks and opportunities.

What gives us confidence in India’s case is directional clarity on government spending and regulation. Such preconditions promise to create tailwinds that companies can benefit from.

Collaboration across investment desks is valuable, too. For one Indian renewables firm whose bonds we invested in, our Asian equities team was able to tap into their fixed income colleagues’ insights on its balance sheet and capital structure. They learned how they had engaged with this company and what progress the firm had made on key ESG topics.

The two teams also discussed whether the company was well understood by the market. Market misunderstanding often leads to mispricing and opportunities to generate alpha.

As a firm, abrdn uses proprietary tools and technology to calculate the carbon intensity of portfolios and how that fits with our conviction on whether companies can transition. We know that companies transitioning from brown to green can enjoy an uplift in valuation.

From a portfolio perspective, we believe in balanced exposure to best-in-class companies and what we call “improvers” – firms with scope for improvement in practices or disclosures.

“Understanding ESG risks and opportunities enables investors to value a company’s securities and understand how a portfolio may perform.”

ESG a universal theme

As recently as five years ago, sustainability was considered a theme for equity investors only. But bond investors are key stakeholders with vested interests in company sustainability, too.

ESG integration and company engagement are key to risk management for our fixed income team. Like their equity colleagues, it helps them to understand potential tailwinds from macroeconomic drivers.

There’s strong correlation between companies’ credit ratings and ESG ratings – the better their credit rating, the higher their ESG rating.

Importantly, engaging with bond issuers to help manage their ESG risks can create alpha via spread compression as investors come to recognise the improvements. Allocating to transition and improvement is where investors can benefit.

One power generation company transitioning from coal to renewables saw its bond spreads compress over time as the market appreciated the improved sustainability of its strategy.

Encouragingly, issuance of green, sustainable and social (GSS) bonds and sustainability-linked bonds – collectively known as labelled bonds – has grown rapidly in recent years (see chart).

But while this creates increasing opportunities for fixed income investors to allocate sustainably, we have observed variations in the quality of sustainable financing frameworks and the resulting outcomes delivered.

Sometimes we see minimal requirements on issuers in terms of impact or how they invest the proceeds. That’s why it’s crucial for bond investors to look beyond the label and focus on a company’s overall strategy.