ESG
(Environmental, Social and Governance)
Traditionally, the primary concern of investors has been the level of returns provided by an investment, with general ambivalence towards how those returns have been generated. Now, the industry is seeing a drive towards responsibility in its stewardship of investor money, with investors seeking to understand how their savings are being invested.
Ethical or responsible investing is not a new development, with many asset managers offering funds or investments under various guises; responsible, ethical, sustainable, socially conscious or impact investing are terms that you may have seen, almost interchangeably in many cases. A set of standards have developed in the industry to evaluate how companies operate in respect of the world around them, the people they deal with and whether they govern themselves in a responsible manner; these are termed ESG, for environmental, social and governance.
What does this mean?
ENVIRONMENTAL
How a company interacts with its environment, so disposal of waste, use of energy, sustainability of resources, carbon footprint or compliance with environmental regulations.
SOCIAL
How a company interacts with people, whether that is staff, local communities or suppliers.
GOVERNANCE
How a company is governed. This can mean rights of shareholders, avoiding conflicts of interest and making sure that the remuneration of directors is transparent.
ESG investing seeks to quantify and evaluate companies in these three categories, guiding investment into companies that are well governed and treat the world, their communities and staff in a responsible manner.
Fund managers are integrating these ESG criteria into their asset selection in varying degrees, with many managers building their entire research and selection process from the bottom-up to ensure that the companies in which they invest operate to these standards.
Further to the ESG criteria, there are a number of more targeted approaches that investment managers use as part of specific sustainable or responsible strategies. Here are some examples :
- Thematic investing
Directed investment into specific themes, such as tackling climate change, transition of energy usage to sustainable sources or future water and food shortages.
- Positive and negative screening
Positive screening is simply adding companies that exhibit responsible behaviour to a whitelisted universe in which to invest.
Negative screening is the opposite, screening out companies that invest in unsustainable, controversial or
-Impact investing
A strategy whereby investment is focused into responding to social or environmental needs and making a positive impact.
- Active Ownership
An investment manager with a strategy of activism will not necessarily stop investing in companies which do not fulfil ESG criteria, but will engage the board of directors to encourage change.
Investment managers may use some, or all, of the above as part of their ESG strategy.
There appears to be a growing opinion in the investment industry that companies that fit ESG criteria are well equipped to manage risk and operate in a sustainable manner in the future, so therefore are attractive investments in their own right. To this end, many investment managers are integrating ESG methodology into their investment processes from the ground up, rather than incorporating them into specific ethical or socially conscious strategies alone.
Traditional thinking on the necessity of giving up growth for ethical or responsible investing is also being reconsidered.
Many studies have highlighted that the investors of tomorrow will insist on positive impact as well as positive returns, so ESG methodology is now part of the mainstream and is here to stay.
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Environmental - the 'E' in ESG
The assessment of how a company interacts with its environment is one of the three key factors in understanding ESG risks and opportunities. This is the ‘E’ in ESG.
Fundamentally a measure of a company’s impact on the natural or physical environment, this could be related to use of natural resources, policies on business travel or how it reduces waste in its operations, for example.
Climate change is perhaps the most significant of challenges facing humanity, and therefore one of the most important elements in assessing ESG factors; this is because of the likely impact that climate change will have on every aspect of our lives but also because of the regulatory and societal changes that will be required to combat it. Planning for and reacting to these changes will mean that companies will either be able to thrive or will struggle as world governments make the necessary policy changes.
Therefore how a company contributes to greenhouse gas emissions, its carbon footprint, its use of resources, its waste policies and its energy needs are all important to understand. Companies that do not consider the impact of their businesses on the environment are also leaving themselves open to regulatory sanctions, criminal prosecution and reputational damage, which will all have an effect on the balance sheet and therefore shareholder value of the company.
It is also believed that the current markets have not priced in the inevitable changes to governmental policies that will take place as the realities of climate change become apparent. This will mean that we will see tangible financial impacts to companies that are not prepared to move with the decisive changes likely to take place.
Climate change is also likely to result in more frequent and more damaging meteorological events, resulting in the risk of significant financial losses which will need to be factored in to any assessment of a company.
Aside from the various impacts of climate change, there are a number of other factors that are important to understand. The transition to a circular economy, eliminating waste and making continual use of resources, is likely to be painful and necessary. Therefore how a company makes use of resources and how they deal with waste is a key factor.
Finally, energy considerations are far reaching and impactful; use of sustainable energy, reduction of fossil fuel usage and reduction of carbon footprint are also part of the assessment of ESG factors.
A company that is placed to make efficient use of resources, cope with regulatory change and take advantage of opportunities as society inevitably reacts to changes in the natural world will be at less risk to shareholder value than companies who risk sanctions, reputational damage and loss of earnings as a result of short-sightedness of environmental impacts or interact with their environment recklessly or in a damaging manner.
Governance - the 'G' in ESG
The assessment of how a company is governed is one of the three key factors in understanding ESG risks and opportunities. This is the ‘G’ in ESG.
The factors in this part of the ESG assessment all relate to how a company is governed; that is, how it makes its decisions, how its board of directors is established, operates and is remunerated, how it manages its risks and how it deals with the rights of shareholders.
There are many factors that make up the assessment of how a company is governed; some related to the company culture and its decision making processes but others that stray towards social factors, such as gender representation on the board of directors.
A company that is governed well works within its regulations and policies and is transparent and fair. Good governance mitigates and controls risks to avoid mismanagement, potential scandal and regulatory sanctions.
Shareholder rights are also key to good governance. Part of this picture is executive remuneration and avoidance of bribery and corruption, denuding shareholder value for the gain of individuals on the board or within the company. Avoidance of any conflicts of interest within a company shows good governance.
There is a natural conflict in many of the governance issues between whether a company is protecting shareholder interests best by simply maximising returns or by minimising governance risks. Tax strategy is one such factor, where it may make sense for a company to reduce the amount of tax paid in a jurisdiction where it is doing business but where the avoidance of tax could cause a feeling of unfairness for people living in that country; one example is the low taxes paid by Amazon in certain countries as a result of the routing of tax obligations through low tax jurisdictions.
Good governance also extends to a company’s data policy and security. Poor security measures can quickly lead to loss of data, inconvenience and financial loss to customers who entrusted their personal details.
Assessing how well a company is governed is therefore an important part of understanding its ESG risks. A well governed company will minimise their exposure to governance risks.
Social - the 'S' in ESG
The assessment of how a company interacts with the people around it is one of the three key factors in understanding ESG risks and opportunities. This is the ‘S’ in ESG.
A company has many social interactions, whether staff, suppliers or customers, and each operates within the dynamics of society and within the bounds of its reputation and demographic. Understanding how this web of social interactions is managed is key to assessing its risks.
Treatment of a company’s workforce is an important part of its ESG assessment. Equal and fair working conditions, remuneration and rights are all expectations of a company that treats its employees well and with respect. An employee should not be treated differently because of gender, race or beliefs.
There are a number of potential consequences for mistreatment of the workforce, from difficulties in retaining skilled staff to strike actions. Likewise, ensuring the safety of staff is an important consideration. Poor health and safety could lead to criminal prosecution, fines or regulatory sanctions.
The same principles of fairness, equality and safety extend outside of the workforce to other groups of people, for example suppliers. This can be especially key when suppliers are based in countries dealing with poverty or poor working conditions.
There are strong values attached to many of these social interactions, with equality and fairness issues, for example, rapidly creating difficult situations for companies that are seen to exhibit poor behaviours or attitudes. This can quickly lead to consumer action or boycotting, and therefore have a material commercial impact.
The goods and services that a company sells can also be a source of controversy and therefore interact poorly with social values; an arms or tobacco company carries implicit ESG risks from the business that it undertakes.
Understanding the social interactions of a company is therefore very important to understanding its ESG risks. A company that treats the people with whom it interacts in a fair and sustainable manner will minimise their exposure to these social risks.
ESG - Active Ownership
Exercising the rights of ownership to influence company decision making is one of the means with which investors can directly affect a company's adherence to ESG principles. This is an important part of investing responsibly.
It is now widely recognised that active ownership is crucial for ensuring that companies are held to task for failings in their governance or their approach to various other ESG challenges, such as climate change, gender equality or policies on resources and waste. This can be achieved by entering into constructive dialogue with company directors or by exercising shareholder proxy voting rights to enforce good behaviours and eliminate poor, unethical or short-sighted behaviours. This type of action can directly improve the long term value of a company whilst also providing positive outcomes for society.
Active ownership is considered amongst the strongest mechanisms to maximise returns, reduce risk and have positive impacts and has been adopted by many asset managers as part of their ESG strategies.
History and Emergence of Responsible Investing
Responsible investing has grown exponentially over the last decade, with an explosion of new thematic funds and the integration of ESG analysis into more traditional stock selection methods, however investing in a responsible manner is not a new concept.
Religious roots
It is believed that religious motivations drove the first examples of responsible investing; whether the Methodist church asking its congregations not to profit at the expense of those around them, or the Quakers forbidding members from profiting from the slave trade. The categorisation of companies or industries as ‘sinful’ is directly from this period of time, with alcohol, tobacco and weapon companies prohibited from investment by parishioners. Islamic principles also sought to avoid investment in companies with activities that are not permitted under Shariah.
The rise of activism
People power, or the positive stewardship of capital, became a driving force from the 1960’s onwards. The avoidance of investment into apartheid South Africa contributed to pressure on the government to end racial segregation. Many other examples were to follow.
In 2006, the ongoing genocide and humanitarian disaster in the Darfur region of Sudan led to the Sudan Divestment Task Force, which lobbied investors in companies operating in the country to disinvest.
BP saw a heavy financial impact following the Deepwater Horizon catastrophe in 2010, with many shocked by the extent of the oil spill and the environmental damage caused in the Gulf of Mexico.
Volkswagen were also heavily fined and saw a fall in share price following the emissions scandal in 2015.
The coming of age for responsible investing
The world’s first sustainable mutual fund was launched in 1971, the Pax World fund, which was created by Methodist ministers in the US who did not want church money to be invested in companies involved in the Vietnam War. The fund is still running today in the US. By 1994, there are only 26 sustainable funds, with assets under management of USD $1.9 billion.
The nineties and noughties saw landmark protocols and agreements globally in respect of environmental and social issues, such as the Kyoto Protocol in 1997, which convened world leaders to set global warming goals, the 2006 UN Principles of Responsible Investing and the Paris Agreement of 2015, where consensus was reached by world leaders to combat climate change.
The responsible investing universe has grown exponentially in the last decade. Estimated net flows into open-end funds and exchange traded sustainable funds in the US totalled USD $20.6 billion for 2019, which is four times the previous annual record set in 2018.
The world of responsible investing is clearly not new but it is now mature, significant in size, effective and, most importantly, available to all.
The United Nations Sustainable Development Goals (SDGs)
At the heart of global development action plans for future peace and prosperity are the United Nations Sustainable Development Goals, which were set out in the 2030 Agenda for Sustainable Development and adopted by all UN member states in 2015.
- Sustainable Development Goal 1 - No Poverty
- End poverty in all its forms everywhere.
- Sustainable Development Goal 2 - Zero hunger
- End hunger, achieve food security and improved nutrition and promote sustainable agriculture.
- Sustainable Development Goal 3 - Good Health and Wellbeing
- Ensure healthy lives and promote well-being for all at all ages.
- Sustainable Development Goal 4 - Quality Education
- Ensure inclusive and equitable quality education and promote lifelong learning opportunities for all.
- Sustainable Development Goal 5 - Gender Equality
- Achieve gender equality and empower all women and girls.
- Sustainable Development Goal 6 - Clean Water and Sanitation
- Ensure availability and sustainable management of water and sanitation for all.
- Sustainable Development Goal 7 - Affordable and Clean Energy
- Ensure access to affordable, reliable, sustainable and modern energy for all.
- Sustainable Development Goal 8 - Decent Work and Economic Growth
- Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all.
- Sustainable Development Goal 9 - Industry, Innovation and Infrastructure
- Build resilient infrastructure, promote inclusive and sustainable industrialization and foster innovation.
- Sustainable Development Goal 10 - Reduced Inequalities
- Reduce inequality within and among countries.
- Sustainable Development Goal 11 - Sustainable Cities and Communities
- Make cities and human settlements inclusive, safe, resilient and sustainable.
- Sustainable Development Goal 12 - Responsible Consumption and Production
- Ensure sustainable consumption and production patterns.
- Sustainable Development Goal 13 - Climate Action
- Take urgent action to combat climate change and its impacts.
- Sustainable Development Goal 14 - Life Below Water
- Conserve and sustainably use the oceans, seas and marine resources for sustainable development.
- Sustainable Development Goal 15 - Life on Land
- Protect, restore and promote sustainable use of terrestrial ecosystems, sustainably manage forests, combat desertification, and halt and reverse land degradation and halt biodiversity loss.
- Sustainable Development Goal 16 - Peace, Justice and Strong Institutions
- Promote peaceful and inclusive societies for sustainable development, provide access to justice for all and build effective, accountable and inclusive institutions at all levels.
- Sustainable Development Goal 17 - Partnerships for the Goals
- Strengthen the means of implementation and revitalize the global partnership for sustainable development.
For more information visit www.sustainabledevelopment.un.org/
Reposting by POINT Consultant
