ESG Focus: All Aboard The ESG Train

ESG Focus | Nov 28 2018

Who Cares Wins: Why investors will be rewarded if they pay heed to corporate Environmental, Social and Governance credentials.

By Sarah Mills

The powers that be have been diligently laying the foundations for a transformation of global human affairs for the past two decades.

The board game has been set and the pieces are in place. Governmental bodies have been established; global compacts agreed; investing frameworks established; goals, benchmarks and indices developed; and what was a trickle of regulations is about to become a river along which capital will flow.

The upshot will be disruption in global financial markets. Huge pools of global capital will be withdrawn from some products and industries and invested in others; new financial markets and products are being developed; and companies are looking for ways to use the new order to build profitability moats against their competitors. Investors will want to be on the right side of these transactions.

Catalyst is coming of age

The catalyst for this transformation is the concept of Environmental, Social and Governance (ESG) investing. Once the subject of cynicism, thanks to the failure of its toothless prototype, Corporate Social Responsibility, industry mavens, from Harvard to Cambridge, now claim the evidence is in: studies going back 20 years show that companies with strong ESG strategies outperform those that don’t.  

A Harvard paper titled Corporate Investment in ESG Practices published in 2015, shows ESG improves an organisation’s marketing and accounting performance; cuts the cost of capital, engages key stakeholder and boosts business reputation.

The Harvard Business Review says the results are very consistent: “firms making investments on material ESG issues outperform their peers in the future in terms of risk-adjusted stock price performance, sales growth, and profitability margin growth.” As companies have a duty disclose information that may affect their bottom line, these findings proved a game-changer.

Major funds now use environmental, social and governance filters when making their investment decisions; chairmen of the world’s largest corporations estimate nearly half of their time is being consumed with managing ESG risks; and a large and rapidly growing industry in ESG advice has been spawned – in part reflecting the complexity of the endeavour.

According to Morgan Stanley, more than $22.8trn in global funds are invested sustainably, representing more than $1 in every $4 under professional management. In Australia, responsible investment strategies now represent 12% of funds under professional management. The Responsible Investment Association of Australia 2017 Benchmark Report says assets under management using responsible investment principles jumped 9% to $622b in the year to December 31, 2016, representing nearly half (45%) of all professionally managed assets in Australia. Core ethical investments – those aimed specifically at making a positive impact on sustainability – rose 26% to 4% in the same period.

FNArena believes that the time has come to report regularly on ESG. To help our members catch the ESG tide, we will be covering a range of ESG subjects, such as its impact on asset classes, industries, companies and fund managers.

Our website now includes a dedicated section -ESG Focus- and we will be reporting regularly on further developments that have financial materiality to Australian stocks.

Defining ESG

ESG standards were designed to help investors avoid firms at risk of suffering financial losses arising from poor practices in environmental, social and governance practices. They align closely with the three megatrends sweeping the world: climate change, cyber-security and inequality; all of which pose substantial risks to companies globally: economic, environmental, geopolitical, societal and technological risks.

Global asset manager Robeco, which manages Euro246b of assets, uses the following definition for ESG investing:

“The pursuit of superior financial returns coupled with positive environmental, social and corporate governance outcomes.”

As the term suggests, they aim to encourage corporations to respond to climate change, treat their workers well, build societal trust, foster innovation and better manage their supply chains.

  • The ‘Environmental’ refers to issues such as waste, pollution, natural resource conservation, the treatment of animals, climate change, clean technology, and water management.
  • ‘The Social’ refers to health and safety, treatment of local communities, human rights, human resources, labour and working conditions and focuses on ensuring suppliers to corporations hold these positive values.
  • ‘The Governance’ refers to reporting, the adoption of accurate and transparent accounting methods, disclosures, conflicts of interest, illegal behavior, compliance and regulation.

A history with sterling credentials

The lasso being used to rope corporations into line on ESG is essentially disclosure. The history of ESG harks back to the year 2000 when the UN launched the Global Compact, and established the Principles for Responsible Investment – the most powerful of which was arguably Principle 3 which sets the guidelines for ESG disclosures by companies.

In 2004, former UN Secretary General Kofi Annan wrote to the CEOs of 50 major financial institutions inviting them to participate in a Global Compact initiative, supported by the International Finance Committee and the Swiss government, to find ways to integrate ESG into capital markets. The actual term ESG was then coined in 2005 in a study by Ivo Knoepfel with the distinctly ‘get with the program’ title of Who Cares Wins. Armed with this report, and the Freshfield report; both of which argued that ESG was good for business, the Principles of Responsible Investment were then launched in 2006 at the New York Stock Exchange, followed by the Sustainable Stock Exchange Initiative in 2007.

In 2011, the European Commission determined organisations must disclose non-financial information that has a material impact on performance and determined which international framework would serve as a standard reporting guideline to be integrated into annual reports.

Then in 2015, the United Nations Climate Change Conference of 190 nations signed the Paris Accord, which aims to strengthen the international response to keep global temperature rise well below 2 degrees this century. A work program was created to develop modalities, procedures and guidelines on a broad range of issues. Also in 2015, at the UN Sustainable Development Summit, the 2030 Agenda for Sustainable Development was published containing 17 sustainable development goals (SDGs). The Sustainable Accounting Standards Board (SASB) then developed industry-by-industry accounting standards that identify the material ESG issues that could have financial implications for a company. Then the 2015 Harvard paper ‘Corporate Investment in ESG Practices published in 2015, proving the link between ESG and financial performance, opened the floodgates. Most recently, the 2018, the European Commission Action plan lays the groundwork for mandatory risk disclosure in Europe.

Add to this raft of governmental crafting, the advent of big data and improved computer processing power, and the stage is set. Since 2015, fund managers and corporations have been on the hop.

Major advisory services, ratings agencies, stock exchanges and news agencies such as Bloomberg and Reuters, have also been quietly establishing an ESG presence, building expertise and developing strategies.

The impact of ESG investing is expected to vary widely according to the industry. While the rapidly growing array of sustainability indices may provide a first-level filter, fundamental analysis will be needed to grind down to individual companies and their supply chains.

According to a study by the University of Cambridge Institute for Sustainability Leadership, the most vulnerable industry will be real estate, followed by basic materials, construction and manufacturing. The best performers are expected to be transport, agriculture and consumer retail. Pundits predict that investors will seek to mitigate risks initially by switching from one class to another, and through cross industry and regional diversification, and from company to company, until the risk is priced in and markets witness a return to a “new normal”.

Sovereign risk will be important. Some countries will fare better than others: most likely western nations given inequality has a big ESG weighting.

ESG investing basics

ESG investing is divided into three main categories:

  • Exclusions, or negative screening: which excludes companies, countries and industries: such as the “wages of sin sextet”, which include weapons, alcohol, nuclear power, gambling and pornography. Fossil fuels is also finding its way on to the sin-list as are practices, companies and countries found to be in breach of the UN Global Compact.
  • Integration, or Best in Class, screening: which does not apply exclusions but instead applies an ESG filter across all industries and allows funds to invest in the best-in-class company in each industry. Such investment should prove a strong incentive to corporations seeking capital to lift their ESG game to investment grade.
  • Impact, or positive screening: which invests in companies that have the greatest impact (often on the environment) by pioneering ways to use resources or improve equality, in areas such as water, energy, materials, food and health.

Some fund terminology divides ESG investing into just two categories: ‘Broad investing’ (which is basically ‘best-in-class” integration) and ‘Core investing’ (which is basically ‘impact’ investing).

A more in-depth breakdown of these categories will be provided in a separate report but essentially, the Integration, or Best in Class, approach is the one which is driving the greatest change in financial markets as it is the most commonly applied, particularly given some ESG indicators, such as board diversity, provide predictive value of stock returns.

We hope you will join us for front row seats in what is shaping up to be one of the defining new trends in global investing for the decade ahead.

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