Environmental, social and governance-focused investing has ballooned in recent years as companies realise ignoring social impact carries both financial and reputational risk. Not only that, but accessible products, such as exchange-traded funds, make the sustainable route increasingly appealing. Adrienne Klasa reports.

ESG

On November 21, 2018, Mark Carney, the governor of the Bank of England, gave a speech at St James’s Palace. The occasion was a royal birthday, but that was not the topic of his missive. Instead, Mr Carney talked about challenges posed by climate change to the financial industry. 

“[Two-thousand and seventeen] set a record for weather-related insurance losses at about $140bn. Losses in 2018 may again be among the worst in history,” he said. These impacts are real, and present systemic risks to the financial worlds. Insurers, he said, should start stress testing for climate impacts.  

Banks have also begun to adapt – though not quickly enough for some. “Our latest report finds that the majority of banks are starting to treat the risks from climate change like other financial risks – rather than viewing them simply as a corporate social responsibility issue,” said Mr Carney.

Knowing but not doing

A 2018 study by the Bank of England shows that while 70% of UK banks recognise that climate change poses financial risks, only 10% “manage these risks comprehensively and take a long-term strategic view of the risks”.

In a world that is rapidly changing, companies, investors and providers of capital are coalescing around the idea that there is a fundamental problem with the models of capitalism inherited from the 20th century. The explosion of environmental, social and governance (ESG) investing reflects this dawning reality.

Sometimes called ethical, sustainable or responsible investing, allocation to ESG has grown exponentially over the past few years as investors wake up to the risks and see the opportunities, this newer approach to capitalism presents.

According to the Global Sustainable Investment Alliance, today $22,900bn of professionally managed funds are under responsible investment strategies, up by 25% since 2014. ESG investment, on this account, now accounts for one-quarter of assets managed worldwide. Green debt issuance, meanwhile, hit a record $155.5bn in 2017, a 78% jump from 2016, according to Climate Bonds Initiative.

“The sheer volume of market participants is so much higher than it was even two or three years ago,” says Aled Jones, head of sustainable investments for Europe, Middle East and Africa at FTSE Russell, the data service and index provider. “Asset owners and investment managers are focused on this, but we’re also seeing much more interest from investment banks and central bankers are talking about it quite regularly and trying to understand these impacts.”

Regulatory pressure

The Bank of England has been at the forefront of this, but other regulators, including the EU’s pensions and insurers authority, have indicated they could soon require ESG risk reporting from members. China’s central bank, meanwhile, is pursuing greater ESG disclosure from companies and creating 'green finance pilot zones' to support innovation in its fast-growing climate finance sector. As of 2017, China was the world’s second largest market for green debt.

Index providers including FTSE Russell, MSCI and S&P Global all see ESG as a growth area for their businesses. In 2017 alone, the number of responsible investment-focused funds doubled – fuelled in large part by growing numbers of exchange-traded funds (ETFs) underpinned by a sustainable investment philosophy.

Vanguard, the world’s second largest provider of ETFs after BlackRock, launched two new responsible investment ETFs in June 2018. One will track US stocks, Vanguard’s first ESG fund to do this, and is expected to swamp others in the market.

BlackRock, the world’s largest asset manager, announced plans earlier in 2018 to start two ETFs that exclude producers and big retailers of civilian firearms, following a high-profile high school shooting in Florida in February. “There are not many conversations with clients these days that don’t incorporate an ESG element,” says Mr Jones at FTSE Russell.

Bad behaviour?

By the late 1990s, two new realities sparked the debate about how corporate behaviour should change in the 21st century. The first was scientific evidence that companies were using up natural resources at a faster rate than they could be replaced. The second was that the market value of companies was shifting from tangible to intangible assets. While intellectual property and information systems are a large part of this, reputation and brand are key.

“We are in a resource-constrained, technologically advanced society where civil society can become a greater disruptor of companies than activist shareholders because of social media,” says Mervyn King, chair of the International Integrated Reporting Council and an authority on corporate governance and sustainability.

“You’ve got absolute, radical transparency and at the same time rapid population growth, so it is quite clear companies have got to make more out of less. Business as usual is not an option any more,” he adds.

In other words, according to Mr King, mid-century economist Milton Friedman’s doctrine that companies should have no social responsibility and focus purely on return maximisation for shareholders is no longer relevant. Companies need to “show investors how [they are] going to sustain value creation in the future”, says Mr King.

He is not alone in this belief. Larry Fink, CEO of BlackRock, penned an open letter to CEOs on the occasion of his company’s 30th birthday. It sent ripples through the business world because he linked long-term, sustainable strategy to financial performance. “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers and the communities in which they operate,” wrote Mr Fink.

Companies who fail to do so, he added, “ultimately will provide sub-par returns to the investors who depend on it to finance their retirement, home purchases, or higher education”.

SDG role

Three years ago, two events helped to consolidate the global consensus around these ideas. First,  in September 2015 more than 190 countries signed up to the Sustainable Development Goals (SDGs), a global framework that envisions a large role for the private sector in driving forward a more sustainable future and development in lower income countries.

Two months later, leaders came together to sign the Paris Climate agreement, which pledged countries to work to limit global warming to 2 degrees Celsius.

Since then, the political mood has shifted significantly in some quarters. The election of Donald Trump’s anti-environmentalist, pro-industry administration in the US has painted adhering to these agreements as a trade-off between the livelihoods of everyday Americans and elites.

The rise of populism in Europe has also made it difficult for policy-makers to push through measures to support the sustainability agenda. In December 2018, French president Emmanuel Macron was forced to backtrack on a promised environmental tax on petrol after rioters stormed through cities across the country. 

And despite all the hype around sustainable investment, the SDGs still face an annual financing shortfall of $2500bn until 2030, according the UN Conference on Trade and Development.

Profit and purpose

Nevertheless, from an investor perspective the ESG movement is continuing to gather momentum. And while part of the motivation may be ethical, there is increasing evidence that, in terms of returns, the narrative of 'trade-offs' some politicians wish to capitalise on does not actually exist.

In 2005, the UN Global Compact released a landmark study called “Who Cares Wins”. In it, the authors set out ideas that were, at the time, considered revolutionary. Drawing inspiration from earlier divestment movements – from, for example, tobacco, alcohol or firearms-producing companies – they went further. The authors argued that ESG investment would not only lead to better social outcomes but that it would serve as a proxy to track the evolution of notions of value and risk.

They posited that alongside the moral and ethical argument for investing along more responsible lines it would bring greater financial rewards. “Companies with better ESG performance can increase shareholder value by better managing risks related to emerging ESG issues, by anticipating regulatory changes or consumer trends, and by accessing new markets or reducing costs,” the authors wrote.

They pointed to the rise of intangible value as a key driver, writing: “It is not uncommon that intangible assets, including reputation and brands, represent more than two-thirds of total market value of a listed company. It is likely that ESG issues will have an even greater impact on companies’ competitiveness and financial performance in the future.”

These words have proven prescient. “Most asset owners [now] position ESG as a risk mitigation approach, although opportunity is increasingly being recognised,” says Mr Jones at FTSE Russell.

Retail interest in ESG – driven by millennials and women, according to research by Bloomberg Intelligence – is increasingly looking at the returns it offers, as demonstrated by the rapid growth of ethical investment ETFs. In October 2018, Mr Fink at BlackRock predicted that assets in ESG-focused ETFs would increase from $20bn today to more than $400bn by 2028.

A selfless act?

Investors are not being selfless by allocating towards ESG, however. Data from both FTSE Russell and MSCI shows a common trend: regardless of the investment philosophy that underpins the ESG index construction – whether it is an exclusion model for fossil fuels, for instance, or engineered to focus on positive climate impact – these indices consistently outperform the wider market (see chart).

This is borne out by research conducted by the Boston Consulting Group. In a 2017 study of more than 300 of the world’s biggest companies across sectors including pharmaceuticals, consumer goods, oil and gas, banking and technology, the authors found that those with more ethical operations were making larger profits and had higher valuations than competitors. “We found clear links between financial and non-financial performance,” the authors said. “Our quantitative analysis showed that non-financial performance on certain topics had a statistically significant impact on company valuations and on margins.”

The dramatic loss in value that can result from reputational damage can be a body blow to a company and its investors. The fates of Miramax, Harvey Weinstein’s former company, and Bell Pottinger, the PR firm that collapsed after a scandal in South Africa, are just two examples.

Believe the hype?

The massive growth in interest in ESG, viewed as positive in most quarters, does raise some questions about hype. “It is exciting, but we’re in stage of flux. Norms, standards and best practices still need to settle, but if they bed down in the right way, we will successfully allocate much more capital in more responsible ways,” says Ben Caldecott, founding director of the Oxford Sustainable Finance Programme at the University of Oxford.

However, he believes there is still “a long way to go in terms of practice and products delivering” on the promised scale. Many topline figures trumpeted by ESG enthusiasts are overblown, he believes, saying: “Clearly if a quarter of assets were invested along ESG lines, we wouldn’t have a problem.” Deeper analysis on the actual impact and parameters of true ESG allocation would likely whittle those trillions down to “more in the tens of billions”, he adds. Loose definitions and lack of clear data and reporting requirements are part of the issue.

Innovations in data collection on company performance across a range of indicators will help. Whereas most ESG data currently comes from companies’ internal reporting, researchers at universities including Oxford and Stanford are working on techniques that employ remote sensing and geospatial data to evaluate companies’ performance on indicators such as carbon emission or water quality.

Mr Caldecott believes that assets and their ownership could be mapped in ways that would allow data collectors to assess damage over time. “It’s a bit like mapping the human genome,” he says.

Big data, artificial intelligence and natural language processing are other promising avenues for ESG data collection. Asset manager Arabesque, for example, has developed a technology called S-Ray, which uses machine learning and big data to scrape data on more than 200 ESG metrics from 50,000 sources in 15 languages.

Deutsche Bank has developed another system called α-Dig, and claims the tool not only picks up ESG-related news signals, but can link it with other contextual information that allows for a more accurate assessment of risk (for instance, linking a report of a lawsuit to a settlement).

These tools claim to be able to cut through the ‘greenwashing’ and corporate spin inherent in companies reporting on their own sustainability performance. In self-reported ESG data sets, “companies that used optimistic language and buzzwords, on average, had higher ESG policy score ratings,” according to Deutsche Bank.

Index companies are also looking to these new kinds of data collection. “Alternative data collection methods will become a bigger and bigger part of what we do,” says Mr Jones at FTSE Russell. But, he adds: “It is still relatively early days [and] mostly small companies are doing work in this area.”

ESG chart

A geographic divide

While Europe leads the way on ESG, with about half of all assets under management adhering to some kind of sustainability criteria, interest is also on the rise in the US, Canada and Japan.

All of these jurisdictions have a few things in common, however: they are already highly developed, wealthy and are among the world’s highest emitters of greenhouse gases. While improvements in big developed markets are important, very little ESG investment is making it to emerging and frontier markets, where it stands to make the biggest difference.

Part of the problem is a paradox inherent in ESG scoring. “How can you reconcile a focus on ESG principles with investments in emerging and frontier markets that are (almost by definition) less well governed, more corrupt and increasingly polluted than developed markets?” ask economists at Renaissance Capital. 

“There is a danger of hypocrisy if... pension fund assets built on imperial foundations [choose] to invest only in Denmark.”

Their breakdown of ESG performance by country shows that, overall, investors are still rewarding bad performers. In both emerging and developed markets, the countries with the worst ESG scores had the best equity market performance in 2018 (Israel and Qatar).  

The bottom line is that ESG investors should not exclusively focus on high performers but look at improvers as well. “Our ESG work suggests investors need to avoid the temptation to draw sharp lines between good and bad companies, or countries,” says Charles Robertson, chief global economist at Renaissance Capital. 

“Engaging with poor ESG performers may be far more effective than ignoring them – just look to the poor governance scores in Equatorial Guinea, Libya and Turkmenistan, which we think is partly because of their complete lack of engagement with investors.”

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