ESG integration in active discretionary strategies. Let's take a closer look at the active discretionary space. Integrating ESG can take a number of forms and the simplest method is to do an initial screen of the stocks in the universe that sets minimum criteria that individual stocks must meet in order to be considered for further analysis and potential inclusion in a portfolio. This is called negative screening where certain stocks are simply excluded from the universe and it's a simple and easy-to-implement approach. However, it's becoming increasingly common for ESG integration to be a result of integrating ESG factors throughout every stage of the security analysis process. This process usually starts with understanding the sector and the company using competitive analysis and scrutiny of the financial statements including analysis of profitability, efficiency, liquidity and solvency ratios. The competitive analysis of the company's products, market position and prospects should incorporate all relevant ESG considerations. It would be at this stage that analysts establish the presence and materiality of ESG risks and opportunities and how the company is managing them.

The analysts would do this by reviewing the company disclosures, questioning the company management or using third party ESG research on the issuer. To help focus on a set of ESG factors and judge their materiality, the analysts could use materiality maps such as those made available by the sustainability accounting standards board, the SASB.

After using such processes and tools, the analyst could conclude that the company is not managing its supply chain sufficiently well based on evidence of worker health and safety violations in the facilities used by its suppliers. That could make the analysts conclude that such violations are likely to impact the company's reputation and sales growth.

Alternatively, the analyst may conclude that as the company addresses these concerns and demands actions from its suppliers or switches to different suppliers, then operating costs will need to increase. In another scenario, the analyst may conclude that in order to comply with new environmental regulations that put limits on emissions or pollution in wastewater, a company may need to invest heavily in upgrades to its production facilities with an impact on capital expenditure.

Having gained sufficient understanding of the company's market, products, services, competitive position, material ESG risks and opportunities, the analyst then forecast the company's revenues, profit margins, earnings, and cash flows for a period of several years. The analyst would need to establish a view on the likely long-term prospects for profitability and growth, again, capturing any relevant long-term ESG factors. The forecast would then serve as inputs into evaluation model. For example, if they use a discounted cashflow model, this would require the projections of cash flows that the analyst expects the firm to generate for the next few years after taking necessary investments into account. The analyst will also need to use some form of terminal value estimates to use in the model, usually based on assumptions of long-term growth into perpetuity. The next stage is to discount the forecasted cash flows to present value, and the key variable here is the discount rate reflecting the cost of capital or to put it differently, it is the required rate of return for investors. So how do ESG issues relate to the discount rate? Well, ideally it would be possible to specify and quantify all ESG related risks and opportunities and in the forecasts of sales profits, capital expenditures and possibly also future liabilities. However, sometimes it's just not possible to do that with any precision. Yet the analyst does want to reflect a particular ESG concern or concerns in the valuation. Adjusting the discount rate is a way to do that. For example, the analyst may have concerns about the company's governance attributes, such as a lack of board diversity or poor linkage between executive remuneration and performance indicators. In such a scenario, the analysts could add a premium to the discount rate, perhaps increasing it by a percentage point. A higher discount rate will then result in a reduction in the present value future cash flows and consequently, a lower intrinsic value for the company.