Investing In ESG: The Lay Of The Land

ESG Focus | Dec 13 2018

Investing in ESG – the lay of the land.

Environmental, Social and Governance (ESG) investing is about to make its presence felt.  PIMCO, one of the world’s largest bond managers, estimates between $3trn and $5trn will be required annually if the United Nations is to achieve its Sustainable Development Goals (SDGs) by 2030. Most of this will be sourced from the private sector.

To service this demand, a range of investment products across asset classes will hit the market; along with indices and benchmarks to assist with ESG screening and portfolio allocations; and a focus on ESG in fundamental analysis at country, industry and company levels.

ESG investing is a fertile field for the advisory industry given its labyrinthine complexity – less so for the average punter. Even the basics of ESG investing do not make for light reading but there’s no place to start like the beginning. It is hoped that this article, combined with the previous article, will arm our readers with the big picture on sustainability as we drill down to the industry and individual stock levels over the year.

The starting point is sustainability

The vast majority of all ESG investing is based on the principal of sustainability.

The commonly accepted definition of sustainability that underpins modern governmental frameworks is that developed by the Brundtland Commission in its landmark paper Our Common Future:

“Sustainable development is the kind of development that meets the needs of the present generation without compromising the ability of future generations to meet theirs.”

It is within this context that definitions have been developed for investment purposes. Robeco, in its Big Book of SI, defines sustainable investing as:

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

One of the early landmark reports in this field of investing was a 2015 paper entitled From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, by Oxford University and Arabesque Partners. It concluded that: “… 80% of the reviewed studies show that prudent sustainability practices positively affect investment performance.” Universities from Harvard to Hamburg have joined the research-chorus and agree that ESG investing is critical to creating long-term value for the shareholders of any business.

Basically, sustainable investing is the point at which profitability/business performance intersects with the above Brundtland definition of sustainability. This point is called financial materiality.

The starting point for defining financial materiality is the United Nation’s set of Sustainable Development Goals.

“The SDGs are taking sustainability to the next level,” says Robeco’s Big Book of SI. “They are making impact investing tangible … It is now up to the financial industry to steer more assets to make a positive contribution.”

The United Nations adopted the 2030 Agenda for Sustainable Development in 2015. Touted as a blueprint for peace and prosperity for people and the planet, it is underpinned by 17 Sustainable Development Goals (SDGs) (URL here please):

  1. No poverty
  2. Zero hunger
  3. Good health and wellbeing
  4. Quality education
  5. Gender equality
  6. Clean water and sanitation
  7. Affordable and clean energy
  8. Decent work and economic growth
  9. Industry, innovation and infrastructure
  10. Reduced inequality
  11. Sustainable cities and communities
  12. Responsible consumption and production
  13. Climate action
  14. Life below water
  15. Life on land
  16. Peace, justice and strong institutions
  17. Partnerships for the goals.

A wealth of investment opportunities present themselves in the above SDG list, ranging from energy, to food, to healthcare to construction, to materials, to water management and to technology, but the question remains: how and where to invest US$3-5trn? In the end, it’s all about the money, and not all of the SDGs have financial materiality.  

Enter the Sustainable Accounting Standards Board (SASB). The SASB is a non-government organisation funded by philanthropists, companies and individuals. It has produced a map of materiality to help investors and companies determine which points will impact their bottom line. It has also integrated its provisional standards for 79 industries across 11 sectors into the Form 10-K, which must be filed by public companies with the US Securities and Exchange Commission.

There are many areas in which SDG materiality overlaps. For example, each of the goals has sub-goals by which the success of the master SDG goal is measured, and often only a few of those offer opportunities for investors. As an example of one approach to managing this, asset management firm Robeco has developed impact categories – areas where material SDGs overlap – and has created scorecards based on the following five categories:

1. Basic needs (SDG 2, 3, 4, 6)

2. Healthy planet (SDG 7, 12, 14, 15)

3. Sustainable society (SDG 8, 9, 11, 13)

4. Equality and opportunity (SDG 1, 5, 10)

5. Robust institutions (SDG 16, 17)

Such mapping processes flow down to industries, which can also be grouped according to SDGs and implemented on a standalone basis or in combination – most can be implemented across asset classes. Like I said, it’s complex.

Environmental, Social and Governance

To help clarify the situation, sustainable investing (SI) has been broken down into three main areas: environmental, social and governance investing (ESG). Unlike the simple, aspirational, investments opportunities offered by SDGs, ESG is all about financial materiality and risk – economic, environmental, societal, geopolitical and technological risk.  Poor management of these risks has been proven to be very costly. For example, BP's 2010 oil spill and Volkswagen's 2015 emissions scandal rocked the firms' stock prices and resulted in billions of dollars in losses; and on a more abstract note, boards with greater diversity have been proven to post better performances over the long term.

ESG standards and screens have been developed to help investors avoid firms at risk of suffering tangible losses as a result of poor ESG practices. Boards have a fiduciary obligation to manage risk for the purpose of sustaining and increasing profits. ESG’s key drivers are regulation and disclosure, which will create a very tight risk and reward channel through which corporations and investors will wish to steer.

  • The ‘Environmental’ refers to issues such as waste, pollution, natural resource conservation, the treatment of animals, climate change, clean technology, and water management. For example, as the disclosure net tightens, companies that manage water and energy more efficiently will be rewarded as it has a direct impact on the bottom line.
  • ‘The Social’ refers to health and safety, treatment of local communities, human rights, human resources, labour, working conditions and human rights and focuses on ensuring suppliers to corporations hold these positive values.  Inequality is a problem for investors because it dampens investment and productivity and undermines economic growth. It also has the potential to trigger macroeconomic and financial disruption. Inequality also affects sovereign credit quality. This is likely to affect fixed income markets and, as regulation is introduced, companies with poor practices in their supply chains.
  • ‘The Governance’ refers to reporting, the adoption of accurate and transparent accounting methods, disclosures, conflicts of interest, illegal behavior, compliance and regulation. Study after study has proven more diverse boards and transparent organisations outperform in the longer term. Again, as the disclosure net tightens and ESG screening mechanisms are implemented, companies with strong governance will attract greater capital through equity and bond markets.

These three jewels have been framed within an intricately forged crown of risk and many of those risks have been rated from an operational, regulatory, reputation, health and safety and waste management perspective.

The three approaches to ESG investing

ESG investing is divided into three investing approaches:

  • Exclusions
  • Impact
  • Integration

Each approach tends to loosely align with either the E, S or G.

Exclusions, or negative screening, excludes companies, countries and industries considered unethical. It tends to include the “wages of sin” sextet of weapons, alcohol, nuclear power, gambling, tobacco and pornography. Fossil fuel is finding its way on to the sin-list, as are practices, companies and countries found to be in breach of the UN Global Compact. It tends to align strongly with the Societal element of ESG and to some degree, Environmental.

It is essentially ethical screening. Exclusion investing is problematic for investors as it often involves forgoing profits for ethical reasons and leaves a relatively small pool of potential investments and offers little clear financial upside.

Impact, or positive screening, 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, population and health. Examples include electric and hybrid vehicles, wind turbines and solar farms, bio-plastics, precision farming, lightweight carbon fibre, cutting-edge robotics, wearable fitness devices, mass-market organic food, and advanced water collection and filtration systems. The highly successful launch of A2 milk is an example of the growth offered by those who tap into under-served markets in these fields.

Impact investing aligns strongly with the Environmental and Social components of ESG. It also aligns closely to the Sustainable Development Goals so, to the extent that it matches “the program”, its prospects are strong.  It is likely to feature strongly in the IPO market.

On the downside, positive screening, like negative screening requires a narrow focus and high conviction, it can usually comprise only a small part of a portfolio; and investments are often illiquid with no track record – a punters market.

Integration, or Best in Class, investing is the method that is expected to drive the greatest change. It is the tug boat that will guide the market into the port of sustainability. It aligns closely with the G in Governance and involves investing in companies in each sector with the best ESG practices – this is where the beauty of financial materiality and disclosure and transparency regulations becomes apparent.

It does not apply exclusions but instead applies an ESG filter (based on the SDGs and governance principles) 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. Evidence shows that organisations and countries with best ESG practices are likely to outperform their peers in the long term. For example, ESG indicators, such as board diversity, provide predictive value of stock returns. Financial materiality also exists in company operations: energy and water efficiency for example will result in lower energy and water costs.

The beauty of Best in Class investing is its scope. It can be applied across all asset classes, giving investors access to the greater market.

Growing asset classes and products

With the advent of “Best in Class” investing, the opportunities for ESG investing have grown, providing opportunities to build a diversified portfolio in a broad mix of assets, products and companies. They include:

  • Equities
  • Fixed income
  • Initial public offerings
  • Microfinance
  • Project financing
  • Private equity

The bond market is a case in point. Fixed-income giant PIMCO believes the bond market in particular, will prove fertile ground: “We are on the cusp of a sea change in social bond securities related to issues such as water access, sanitation, gender, health and other social-related infrastructure areas,” says PIMCO.

PIMCO believes debt instruments are ideally suited to the SDG arc to 2030 and predicts a blossoming market in SDG bonds, either general or thematic, based on the Sustainable Development Goals, such as the Asian Development Bank’s gender bond. It expects green bonds to rise 60% in 2018 to $260b.

The UN Global Compact is expected to launch a “Blueprint for SDG Bonds”– a blueprint for companies, investors, sovereign nations and municipals on definitions, development and impact measurement.

ESG screening

Asset allocation – the first ESG screen

With the assets of course comes a process for asset allocation. According to Russell Investments, at present, 55% of wholesale funds are subject to an ESG filter, and 12% of funds through the share market. There is growing incentive to increase the availability of ESG screens to the retail market. The development of indices is facilitating this and the bigger names so far include:

  • MSCI indices
  • Dow Jones Sustainable Indices
  • S&P indices

Robeco says the first step in their approach to ESG integration at the asset allocation level is to determine the ESG rankings of traditional reference indices. For equities, they then calculate an ESG rank of different country or sector-indices by weighting the rank of each company in the index with its index weight. It notes that stocks in the Eurozone, Britain and Australia have significantly better ESG rankings than stocks in the US or emerging markets.

Investing by industry – the second ESG screen

Indices are the go-to point for ESG filters and asset allocations, but, like a Google algorithm, they can only go so far. The next step is to develop a scoring framework for industries. A plethora of frameworks are being developed against a range of ESG criteria. For example, Morgan Stanley has developed an inclusive growth framework that ranks companies according to how well they incorporate inclusive policies in their workplaces, given the profit-enhancing benefits of such policies.

“Many benefits can arise from corporates creating an inclusive workplace,” says Morgan Stanley in its report: Sustainability & Australia in Transition: Investing in Inclusive Growth. “For example, companies that focus on employee engagement tend to experience better performance. Evidence suggests companies with high levels of employee engagement can see EPS growth of up to 4.3x above peers. In addition, more gender-diverse companies experience higher ROE, lower accruals and lower ROE volatility than less-diverse peers.”

Fundamental analysis – the third ESG screen

Scoring frameworks, like indices, only go so far.  ESG is increasingly becoming a core part of traditional fundamental analysis. This is the pointy end of the investment stick: it is where operational costs such as water and energy efficiency are defined for individual companies and their industries.

This reflects the understanding that ESG investing will affect industries differently. For example, energy consumption has a significant effect on manufacturers’ bottom lines; fuel is more important to airlines than for banks; and water management is more important for miners.

Who cares wins

In summary, there is a new kid on the investment block. Her name is Sustainable Investing and she’s wearing a cap that says: “who cares wins”.

The winners in his game will be those with capital and astute first movers.

Cashed up corporations will be able to build profitability moats against their competitors by adopting ESG standards; start-ups and innovators in these fields will receive a leg up; and investors will be rewarded.

Those with neither the will nor the war chests will suffer as capital flows, guided by regulation, sort the chaff from the hay.

Welcome to the brave new world of ESG investing.

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