How to Evaluate ESG in Cash Investments

While environmental, social, and corporate governance (ESG) investing became something of a political hot potato in 2023, it’s increasingly clear that ESG isn’t likely to go away.

Treasury professionals responsible for their organization’s institutional cash investment portfolios need to understand the ins and outs of ESG investing. But with more than 100 ESG data ratings services to choose from and a lack of consensus on performance metrics, developing clear methodologies for assessing ESG characteristics can be a challenge.

Treasury teams undertaking this task should focus on best practices and maintain healthy skepticism when conducting ESG analyses. This will help them determine why, when, and how to factor ESG considerations into their cash investment policies and portfolio strategies.

Cash Investing: Late to the ESG Party

Fixed income was one of the last areas in which ESG investing took hold. And within the fixed income world, institutional cash investors have been particularly slow to turn to ESG strategies. Thus, cash investments represent one of the last miles on the corporate path to full ESG integration.

That said, we have seen a pickup in demand for ESG implementation among cash investors following the increase in public scrutiny of company operations, the global pandemic, and Russia’s invasion of Ukraine. Cash investors may no longer be able to overlook ESG investing, as more and more finance professionals are asking how an ESG approach to cash can be used to benefit the company’s overall investment strategies.

What Is Unique About Cash?

Credit analysts, whether assessing cash investments or not, have always been ESG analysts to a certain degree. Credit and ESG analysts often scrutinize overlapping risk factors and assess the organization’s material exposures to them. However, incorporating ESG data into cash portfolios helps credit analysts track ESG topics on a quantitative basis, whereas they may have followed them only qualitatively in the past.

Compared with long-term credit and equity investors, cash investors typically work with much shorter time frames. Many of the traditional ESG risks, such as the risk climate change poses to companies’ physical assets in low-lying coastal areas over a 30-year horizon, are less relevant to short-term cash investments. Therefore, governance and social factors are often weighted more heavily than environmental impacts.

Cash investors also tend to work with a smaller group of large, well-known issuers, so how an ESG strategy is implemented in a portfolio can have a significant impact, particularly when it comes to issuer diversification. It’s imperative for cash investors to develop their own approach to implementing an ESG strategy, rather than adopting one constructed by a financial firm that doesn’t deal with cash. However, not every cash investor is in the position to develop an ESG approach on their own; it may be wise to partner with an adviser that can help them get aligned with an ESG strategy, backed by credit and risk research based on their organizational goals.

Where to Start

Step 1:  Source ESG data that fits your portfolio’s needs.  Often, the first step for analysts looking to incorporate ESG considerations into their portfolio is to partner with an ESG data provider or ratings service such as MSCI or Sustainalytics. ESG databases enable users to gather, sort, understand, and compare ESG factors across multiple credits. This is particularly useful for smaller firms, which may not have a dedicated ESG team.

However, analysts focused on cash investments cannot take broad ESG datasets at face value, as they are not aimed primarily at cash investors. Rather, they serve a broad and diverse audience focused on all types of investments. Additionally, unlike in the world of credit ratings, not all ESG data or score providers assess ESG in a similar manner.

For that reason, it’s important to look closely at exactly what data each service collects and how it arrives at its ESG ratings. Knowing the pros and cons associated with the ESG ratings services can further inform cash investors’ decisions. After accepting a ratings agency’s methodology, a treasury team can take the data in-house and tailor the broad dataset to fit their specific cash investing risks, or they can find a suitable external service to do so.

Step 2:  Consider options for ESG portfolio overlays.  Next, cash investors need to establish an internal scoring system that reflects the unique risks associated with cash investing, to serve as a baseline for constructing an ESG portfolio. An internal ESG score can enable investors to establish an exclusionary overlay on a cash portfolio. An exclusionary overlay dictating the complete removal of ESG laggards can help provide maximum assurance of maintaining ESG standards in a cash portfolio.

There is a risk that an exclusionary overlay may be too broad. Excluding too many credits—perhaps by cutting certain “sin” industries from the portfolio—may come at the expense of appropriate diversification, particularly for investors working with an already limited universe of issuers. Therefore, it may be worth establishing a more sensitive approach to exclusions, with a lighter touch over a broader range of credits. An ESG-sensitive approach, restricting specific names rather than cutting out entire groups of credits, can help limit downside risk while enabling appropriate diversification within the portfolio.

Along with an ESG-sensitive approach, cash investors should always question common assumptions about the company’s ESG risk factors. To properly screen for risk, analysts may want to view how the company ranks in relation to its peers and the broader peer group’s risk category. For example, oil majors are large investors in the green-energy transition, thus oil-and-gas leaders should not necessarily be excluded from receiving funding, as that exclusion could hamper their sustainability efforts. Additionally, tech companies that are broadly considered to be “good” on environmental impact may have significant shortfalls in consumer protection and privacy policies, leading them to be ESG laggards.

A Proactive Approach to ESG Cash Investing

Institutional cash investors are under increasing pressure to determine whether rewarding a “good” company with a high ESG rating is a good investment decision. In the past, that was a fringe question. Now, when a company is perceived to do well in ESG, it is often seen as adhering to better business practices overall. That may help improve liquidity, bid-ask spreads, and risk profiles.

Investing in ESG is no different from other investments. Treasury professionals need to adjust their tolerance, but at the end of the day, they still need to adhere to principles of cash investing. From a cash management point of view, they are still trying to provide liquidity and protection for their principal investments. Having an ESG overlay shouldn’t divert from the company’s original liquidity and safety goals, but rather help to enhance its ability to adhere to them.

In the end, adopting a careful but proactive stance toward ESG investing may be an appropriate strategy for institutional cash investors. Those analysts who have the appropriate tools to incorporate ESG into their cash investments should not be afraid to use them.

Lance Pan, CFA, is the director of investment research and strategy at Capital Advisors Group, Inc. He provides credit oversight for the firm’s investment process, including credit approvals, strategy recommendations, and the CounterpartyIQ credit monitoring web application.

Pate Campbell is an analyst on Capital Advisors Group’s Credit Research team. He is responsible for conducting money-market, credit, and ESG research to support and maintain Capital Advisors Group’s FundIQ® and CounterpartyIQ® products. Additionally, Pate assists in monitoring approved list credits and writes reports on a variety of topics, from current credit market conditions to sustainable investing.