ESG: Latest developments in a rapidly growing investment theme
THE inauguration of US President Joe Biden has once again thrust climate change into the spotlight, and with it, a renewed emphasis on environmental, social and governance (ESG) investing. With the rapidly changing ESG landscape, we look at some trends that have emerged.
ESG investing began in January 2004, when Kofi Annan, then the Secretary General of the UN, invited major financial institutions to participate in a joint initiative to integrate ESG into capital markets. This eventually resulted in a report titled “Who Cares Wins” by Ivo Knoepfel, and thus the ESG movement was born. The ESG movement was initially held back by two key reasons: it was not seen as important at that time, and the lack of data and tools to collect and analyse the relevant data.
This changed about seven to eight years ago when studies started to emerge showing that good ESG performance is associated with good financial results.
The improvement of technology has also allowed for better data collection and analysis, allowing companies and investors to take the necessary actions in the hope of unlocking better financial performance.
Since then, there has been a remarkable paradigm shift towards ESG investing. While previously thought of as a supplementary consideration, it is now widely used as a key part of fundamental analysis.
With climate change a menacing, pressing issue, ESG investment will continue to remain in the spotlight, and we would like to familiarise investors with some common metrics and strategies that are prevalent in the industry.
The basics
ESG investing, or sustainable investing, is an investment approach that considers environmental, social and governance factors alongside traditional considerations in financial factors when it comes to investment decisions. A breakdown of the factors are as follows:
The social criteria considers a company’s relationships with its stakeholders, as well as how fairly these stakeholders are treated. Stakeholders include but are not exclusive to employees, suppliers, client and communities. Some factors to consider include racial diversification, women representation, and adherence to workplace health and safety.
The governance criteria considers the internal system of practices, controls, and procedures that apply when running a company. Good governance can help align stakeholder interests and help to ensure the long-term sustainability of a company.
Rather than having factors to consider, some basic principles of good corporate governance include accountability, transparency, fairness and responsibility.
The metrics
ESG metrics are largely provided by third party agencies (much like bond ratings) that generally utilise their own methodology to collect and analyse data related to a diverse array of ESG issues.
While ESG reporting standards has come a long way, many challenges remain. Issues relating to finding consensus with ESG metrics and a standardised reporting system remain in limbo.
The complexity of the global geopolitical environment and the differences in operating practices across industries makes a standardised ESG benchmark challenging to establish, and ratings provided by the many ESG rating agencies tend to show low correlation due to the different methodologies used.
Even from the perspective of fund houses, many of them use their own proprietary ESG ratings and measurements. For the truly ESG conscious investor, it is recommended to reconcile these differences by conducting their own due diligence.
The strategies
ESG strategies fall broadly into the following categories, with different levels of ESG incorporation:
Exclusionary ESG screening is generally the standard market practice today. Investors who seek to make a bigger difference in advancing these positive initiatives should look more towards positive selection or impact investing, and can consider some of the examples proposed. However, it is also worth noting that the strategies presented are closer to guidelines
along a scale rather than clear defined categories, and there are likely to be overlaps between strategies. There has also been an increase in the number of fixed income ESG funds available on the market, although these strategies rely mostly on exclusionary screening or positive selection of issuers to meet the ESG criteria.
However, good ESG performance is an important consideration for fixed income investors as well, as poor ESG compliance often leads to regulatory or reputational risk, which could affect the company’s credit and its ability to finance its debt obligations.
While the increased focus on ESG is good for the space (and the world) as a whole, it has led to the rise of another new challenge – greenwashing.
Greenwashing
Greenwashing is the process of conveying a false impression or providing misleading information about how environmentally friendly a product is. With the attention ESG investing has garnered in recent times, greenwashing works as an effective marketing tool to attract ESG conscious investors. Combating greenwashing requires a twopronged approach, from both top-down regulations from governments and bottom-up investor due diligence.
Currently, regulators worldwide are making their move with emphasis on improving regulations in the ESG space. In the US, the SEC is considering updating its naming rule for funds to combat greenwashing, and in Asia, the ASIFMA (Asia Securities Industry & Financial Markets Association) is also implementing new requirements and attempting to establish a common standard across the board.
In the meantime, investors have to rely on their own due diligence. While not exhaustive, here are some tips investors can use to avoid greenwashing:
One good consideration is a fund house’s commitment to ESG investing. Do they have their own proprietary ESG evaluation scale or do they simply rely on third parties? Having their own methodology suggests commitment to the ESG cause, and these companies are more likely to not just include ESG considerations in their asset management, but in the day-to-day running of their company as well.
Another key consideration is whether the fund house can quantify the impact that their investment choices has made.
Finally, investors can look to external ratings to get a good gauge on how closely a fund follows its ESG mandate. Labels and awards are often listed in a fund factsheet, and these awards could be issued by external agencies, such as MSCI, Bloomberg, or Morningstar with its newly acquired Sustainalytics wing. These labels could also be issued by governments or environmental agencies, and are good signs that a fund follows through well with its ESG mandate.