While ESG (Environmental, Social and Governance) may be relatively new as a term, the spirit behind ESG is not. Throughout history holders of financial assets have made decisions based on factors broader than return on investments alone.
In 1758, the Quaker Philadelphia Yearly Meeting prohibited members from participating in the slave trade – buying or selling humans. John Wesley’s (1703–1791) sermon on “The Use of Money” outlined his basic tenets of social investing – i.e. not to harm your neighbor through your business practices and to avoid industries like tanning and chemical production, which can harm the health of workers.
The modern era of socially responsible investing evolved during the political climate of the 1960s. During this time, socially concerned investors increasingly sought to address equality for women, civil rights, and labor issues. For example in 1971 the Pax World Fund, an American investment vehicle, was established. It was the first publicly available mutual fund in America to use social as well as financial criteria in the investment decision-making process. This was intended to make it possible for investors to align their investments to their values.
Awareness of responsible investing grew dramatically in the 1980s as millions of people, churches, universities, cities, and states focused investment strategies on pressuring the white minority government of South Africa to dismantle the racist system of apartheid. And the 1990s saw a rising focus by investors on a diverse range of issues such as tobacco stocks, armaments and sustainable development.
Why companies cannot afford to ignore ESG
Environmental impact is a measure which is under increasing scrutiny from the public and investors. Examples of environmental disasters include:
- The Union Carbide India Limited gas leak which resulted in lengthy legal trials
- The Deepwater Horizon oil spill in the Gulf of Mexico which had huge implications for BP
- The VW “dieselgate” scandal in 2015 caused reputational damage as well as significant financial impact for the company. Questions have been asked about whether better governance could have prevented this
Companies that don’t pay enough attention to social issues such as health and safety or working conditions including slavery and child labor risk both reputational damage and a consumer backlash. Investors are taking note of both the risks and the ethical dimension to where their money is being invested, and asking asset managers to incorporate ESG factors when constructing portfolios and investment products.
How companies are responding
Increasing numbers of companies are responding to societal and environmental pressures by publishing dedicated CSR (Corporate Social Responsibility) reports. Approximately 50 companies produced these in 1993, and this number has now reached over 8,700 companies today according to Corporate Register.
The trend has accelerated in recent times as those same societal and environmental pressures have translated into regulations and industry best practice standards.
81% of the S&P 500 Index companies published corporate sustainability reports in 2015, a vast increase from the 20% that reported in 2011.
Similarly, since its establishment in association with the World Bank’s International Finance Corporation (IFC) in 2003, Equator Principles (EP) have been used by many banks to identify, assess and manage the social and environmental risks of large infrastructure projects they finance. Currently 85 Equator Principles Financial Institutions (EPFIs) in 35 countries have officially adopted the EP, covering over 70 percent of international Project Finance debt in emerging markets.
Is there a potential upside to an ESG investment strategy?
It is evident that selective investment is not new for the demand side. What has started changing in the 21st century is the supply side as more and more providers are taking note of the rising demands of the discerning consumer.
There is significant progress being made with new innovation to help identify new areas of growth through ESG, as corporations recognize that this is not just a moral issue but also a commercial one.
While risks associated with poor ESG are well known including reputational damage, spiraling costs, and business disruptions; there are numerous new opportunities that are surfacing each day.
At the cutting edge of financial product innovation
A growing number of new ESG “thematic” based financing solutions are now surfacing.
For example Thomson Reuters recently launched the Diversity & Inclusion index which focuses on more than 20 criteria that help define diverse and inclusive workplaces, from gender to LGBT friendly, to cultural diversity and workplace training practices. A Thomson Reuters report on board diversity and performance showed that the 100 highest ranked Diversity and Inclusion companies have over time outperformed the Thomson Reuters Global Developed Index benchmark since 2011. Characteristics shown by the top 100 companies include but are not limited to: better return on equity, better profit margins, higher dividend yields and lower beta.
“Progressive corporations that are at the forefront of doing business responsibly are increasingly becoming talent magnets.”
There are a number of financial products purely focused on women in leadership such as Barclays Women in Leadership Index or State Street Global Advisors Gender Diversity Index ETF. Credit Suisse were amongst the first to launch an index that focused on companies with LGBT friendly policies.
Thomson Reuters has also developed an index with an Australian pension fund, which does not invest in any companies which are directly involved in fossil fuel extraction nor which provide services or financing to them. This index has outperformed the benchmark S&P/ASX 200 index since its launch and the fossil fuel free movement is gathering momentum, with HESTA and UniSuper, two large Australian pension funds having announced cuts or divestments to coal and other fossil fuel related companies. In the UK the Guardian just announced that a quarter of all universities in the UK have now divested from fossil fuels.
ESG thematic products have been at the cutting edge of new financial innovations in the fixed income space. The rapid rise in the issuance of “Green Bonds” is seeing a lot of innovation, from the Bank of China issuing “Green Covered Bonds” to the IFC issuing a “Green Coupon” forestry bond. The issuance of green bonds is expected to be worth USD 90bn-120bn in 2017 according to HSBC.
The emergence of artificial intelligence (AI) based ESG solutions from firms like TruValue Labs ushers in a new era of big data analytics that has never been seen before. A new and vast frontier for ESG investing is just around the corner.
What else is driving the growth in sustainable investing?
Asset Owners have arguably been the biggest driver of growth in sustainable investing globally. No longer a simple tick box exercise, asset owners are requiring ever more detail from their asset managers on the inclusion of ESG factors in their investment making decision process. This is in turn creating competition in the asset management space to differentiate and increase the sophistication of their ESG offerings.
Pension funds naturally have long term investment horizons which lend well to the medium to long term ESG criteria. All pension funds are interested in long term value creation therefore it is not coincidental that sustainability factors are well placed to support this.
The UN’s Principles for Responsible Investment (UNPRI) has helped create a common platform for asset managers and asset owners. Signing up to the UNPRI is a basic requirement for many asset managers in order for them to be considered for responsible investment mandates from asset owners.
Regulation and quotas are also driving factors. In France the energy transition law 173 “sets out a roadmap to mitigate climate change and diversify the energy mix. It marks a turning point in carbon reporting, strengthening mandatory carbon disclosure requirements for listed companies and introducing carbon reporting for institutional investors.” [iii]
Numerous countries are adopting quotas whereby publicly listed companies must have a minimum % women representatives on their boards. While this is a start, the progress overall remains very slow.
ESG has been gaining momentum not just with corporations but also regulators and exchanges. Regulators are asking for various components of ESG performance in their regular audits of organizations.
HKEx this year became the first major exchange to start the “comply or explain” code for good corporate governance which sets out a number of “principles” followed by code provisions and recommended best practices.
“With the increase of investment products using ESG factors, rising awareness across every industry, rising alternates and means, and, indeed, rising cost to the human race of any non compliance, it is time for everyone to build sustainable businesses.”
Indices and data tools available for research and sustainable investing
Investors have long recognized that ESG factors are important measures from a risk management and also a compliance perspective. Now we are seeing more and more managers incorporating ESG into their asset allocation process, in a more holistic way, as well as more thematic investment vehicles emerging that appeal to investors who have specific investment objectives.
Unlike financial reports, ESG data is unstructured and can be published at any time of the year. It however needs to be standardized and simplified for analysis. The Thomson Reuters ESG database covers over 6,000 companies globally, and includes 400 ESG metrics, which largely come from company CSR reports. With such a large increase in corporate sustainability reporting set to continue, the investment industry will be able to evaluate the long term health of companies in a more holistic way considering both financial and business sustainability.
It is believed that human beings over-estimate the amount of change that might happen in the short term, but under-estimate the amount of change in the medium to long term. With ever increasing focus from investors, consumers, employees, regulators, and shareholders, there is strong impetus for corporations to progress towards a new era of sustainable value creation. Future winners in each industry will be those who will lead this change through their actions, embracing data, and technology to create sustainable value for all their stakeholders.