For the past few years, there has been growing interest in ESG investments.
Driven by different factors like the shifting global focus, the changing investor profiles, and the development of more advanced data gathering and processing, in addition to studies that showed the positive correlations between ESG performance and firm value (e.g., Fatemi, et al., 2018) and ESG criteria and corporate financial performance (e.g. Friede, et al., 2015), ESG has now grown to become part of mainstream investing.
Of course, there are still quite a number who might actually think otherwise. However, the numbers have shown that ESG investments are surging, with ESG investments now accounting for one-third ($17.1 trillion) of the total $51.4 trillion US assets under management, showing a 42% increase from 2018.
Source: US CIF Foundation
Indeed, sustainable investing has come a long way. From a time when it was considered a niche and was often confused with philanthropy, today, investors are now embracing the concept as they have gained better understanding of the value proposition of ESG integration.
ESG Investing in a Nutshell
|ESG stands for…|
|E – Environmental
S – Social
G – Governance
ESG (Environmental, Social, and Governance) investing, also known as “sustainable investing,” is a strategy used by investors to determine firms that one may likely invest in. This type of investment is based on the premise that certain environmental, social, and corporate governance factors can impact business, and therefore, by looking into these factors, investors are given a more holistic view of firms, which consequently can potentially mitigate risk as well as identify opportunities for growth.
The basic idea is that ESG investors will choose firms to invest in based on criteria set within these categories, of course, in addition to the firm’s financial performance.
As the acronyms imply, ESG has three factors:
The environmental factor covers a firm’s environmental impact. It can be either positive or negative; however, firms who have proven to be good stewards for the environment may highly be more attractive for ESG investors.
While information directly obtained from the firms may give you an idea of how well the firm is performing under the environmental criteria, some firms may have a tendency to exaggerate or paint a different picture than the truth. So, make sure to check out third party sustainability reports that uses respected sustainability standards such as those by the Global Reporting Initiative (GRI) and the Principles for Responsible Investment (PRI).
Some of the highly relevant environmental issues of today that you, as an ESG investor, might look into include:
- The firm’s action plans, policies, and disclosures concerning climate change.
- The firm’s objectives with regards to greenhouse emissions and transparency about how they will achieve these goals;
- The firm’s carbon footprint as well as its carbon intensity (e.g., pollution, emissions);
- The firm’s usage of renewable energy especially for manufacturing firms;
- The firm’s recycling and safe disposal practices;
- The firm’s water-related issues and goals (e.g., water usage and conservation, marine life conservation);
- The firm’s usage or the shift towards green products, technologies, and infrastructures; and
- The firm’s current and past history with the United States Environmental Protection Agency (EPA) and other environmental regulatory bodies.
Meanwhile, the social component factor comprises the people-related elements of the firm. This can include the firm’s corporate culture or any other relevant issues that has an impact on its stakeholders including its employees, customers or consumers, suppliers, the local community, or the general society.
Aside from sustainability reports that uses standards by the GRI or PRI, investors can also check out leading media publications like Fortune and Forbes to gain an insight on how the firms treat their employees. Other media reports can also reflect the firm’s stance on social justice issues.
The following are just some of the important social aspects that ESG investors would look into:
- The firm’s general environment or corporate culture;
- The firm’s general treatment towards its employees as reflected by the management and measured by employee engagement and staff turnover;
- The firm’s compensation packages (i.e., pay, benefits, perks);
- The firm’s efforts on employee training and development;
- The firm’s safety policies for its employees;
- The firm’s diversity and inclusion efforts in hiring and promoting employees;
- The firm’s supply chain sourcing (i.e., ethical/responsible sourcing);
- The firm’s mission (or perhaps lack thereof);
- The firm’s customer service including friendliness and responsiveness;
- The firm’s current and past history with regards to consumer protection issues (e.g., lawsuits, recalls, and other regulatory penalties); and
- The firm’s public stance on social justice issues.
Lastly, governance or corporate governance pertains to the framework that defines the relationship between the Board of Directors, the shareholders, the management, and other key stakeholders. It is essentially the system of policies, processes and rules that dictate the firm’s behavior.
Details on a firm’s corporate governance are usually found on sustainability reports. However, annual proxy statements, which contain announcements about annual meetings, important issues to be voted on, and other relevant supporting information, are also useful.
Some of the governance issues that are useful for an ESG investor’s assessment include:
- The firm’s financial and accounting transparency;
- Information concerning executive compensation packages (i.e., compensation, bonuses, and perks given to the firm’s executives, not just while they are with the firm, but also when they leave the firm);
- Details on compensation that are associated with the metrics that drive long-term business value.
- The diversity of the firm’s Board of Directors, as well as its management team.
- Possible conflicts of interests for the Board of Directors;
- Information on proxy access;
- Information on the Board of Directors and term lengths;
- Information on the firm’s Chairman and CEO (i.e., separate roles);
- Information on board voting (i.e., majority, plurality);
- Information on stock (i.e., dual-class, multiple-class);
- The firm’s transparency of communication with the firm’s shareholders;
- The firm’s past and present lawsuits brought by shareholders, including the nature and outcome; and
- Current and past history of the firm’s relationship with the United States Securities and Exchange Commission (SEC) and other regulatory bodies.
Drivers of ESG Investing
When the concept of ESG investing first came out, it was met with a lot of skepticism. For the most part, institutional investors believe that their fiduciary duty was focused on the maximization of shareholder values. This means that while sustainability looks good on the firm’s press releases, everything else does not matter other than the bottom line. Moreover, they believe that sustainability efforts also produce lower returns compared to the traditional strategies.
Such argument is still prevalent even until today despite contradictory research findings. In fact, there are those who think that ESG investing is just a fad, hence, the rise of ESG investments.
However, many investors and firms have paused to take a closer look on their own investments or their firms and rethink their strategies to take advantage of the ESG framework.
This acceptance of ESG investing is driven by different factors such as the shift in global focus, the changing investor profiles, the development of more advanced data gathering and processing, and recent events concerning the environment, the society, and governance.
A Shift in Global Focus
Image from Canva
The concept of sustainability is not new. It has been around for a few decades already. However, there has been growing pressures from different sectors such as the government and regulatory bodies, capital markets, and consumers to address these issues and perform better.
It should be noted that these global sustainability issues are not limited to environmental issues like climate change, deforestation, and air and water pollution, but also include social issues like fair labor practices, safety, and wellness, and diversity. Likewise, in some parts of the world, poverty and starvation also remain to be a big social issue, including income disparity.
Meanwhile, global sustainability issues also include corporate governance issues like privacy and data security, corruption, and whistleblowing practices. The 2008 financial crisis, for instance, proved how the lack of governance can cause a collapse in the financial market.
These global sustainability issues have inherent risks that are different and more complex, which prompts the modern investor to reevaluate the traditional investment approaches and turn to the ESG framework to incorporate such risks and be able to respond to them appropriately.
Changing Investor Profiles
We are also seeing a change in investor profiles, with more millennials getting into the capital markets. Research has shown that millennials are very particular with how firms conduct business and whether these firms are actively contributing to the betterment of society and the environment in general—be it through the products they purchase or consume, the organizations they work for, or through their investment portfolios.
Aside from the fact that millennials are a massive generation, with roughly 80 million individuals in the United States alone, these younger generation are also estimated to have high spending power, not only due to their employment but given the fact that there are now starting to take over their parents’ (i.e., the baby boomers) estates, giving them more financial flexibility.
Armed with more information and increased awareness, these young investors expect more from their investments but for a variety of reasons. For some investors, they see ESG investing as a means for aligning their personal values with their investments. Using ESG, they can easily see the firms’ activities and intentionally include or exclude them based on their ethical, religious, or political beliefs. Meanwhile, other investors want to take advantage of their money and use it to make a difference in the world. With ESG, they can monitor the impact of their investments through the firms’ sustainability reports alongside their financial returns. Lastly, there are also investors who use the ESG framework because they believe that considering ESG issues will improve the outcome of their investments. Given the complex issues surrounding firms these days, using the ESG framework will help these investors mitigate the their risks better, thus, allowing them to achieve long-term sustainable financial performance.
Development of More Advanced Data Gathering and Processing
The increasing acceptance of ESG investing can also be attributed to the development of more advanced technology. In the past, it was difficult to measure sustainability, wherein socially responsible investing relied on specific activities of firms for inclusion or exclusion. For example, for a long time, firms in the “sin industries” (e.g., tobacco, liquor, gambling) were avoided by socially responsible investors. This can cause problems in the long run as such assessments are subjective and do not take the bigger picture into consideration.
However, with big data and analytics, data gathering and processing has now become easier and cheaper and we are now seeing a more systematic, objective, quantitative, and financially relevant approaches to measure ESG issues. This way, instead of just recommending firms based on their activities with no clear metrics, ESG ratings now allow investors to clearly identify leaders in ESG based on smart algorithms, and not just business type exclusion.
COVID-19 Pandemic as a Sustainability Catalyst
As the world is now slowly opening up its economy, thanks to the fast vaccination efforts of governments around the world, it cannot be avoided that some firms will set aside sustainable approaches to make up for the financial losses incurred during the COVID-19 pandemic. However, the pandemic has showed us that we are all interconnected in many ways and a systemic thinking is crucial in avoiding another looming financial crisis brought about by the pandemic.
The COVID-19 pandemic did not just open our eyes as to our vulnerability to a virus, but also highlighted the vulnerability of our financial system intensifying the case for ESG investing.
Through this pandemic, we saw how our lives are interlocked into a web of economic, environmental, and social systems, even more that we have previously realized. Through this pandemic, we see the effects of poor sustainability practices from the loss of biodiversity (e.g., deforestation) leading to greater likelihood of bringing zoonotic diseases closer to humans. Meanwhile, social issues like income inequality and unequal access to health care and credit have never been more evident during this crisis.
What is very interesting is that firms with high ESG ratings were found to perform better and were more resilient during the pandemic, indicating higher quality and lower volatility among these firms. This crisis proved that awareness, management, and preparation of sustainability risks should be at the heart of a firm’s risk management. It is also important look at sustainability as a whole by incorporating all three elements, instead of an individualistic approach to ESG.
The ESG Research Ecosystem
As ESG ratings are used to help investors see a clearer picture of the different ESG-related risks and opportunities that firms face, it is important to know that there are several components that makeup the ESG research ecosystem.
- Standard setters, who are usually independent or third party organizations that provide ESG standards for firms to adopt;
- Data aggregators, who are organizations that provide an extensive set of structured data gathered from available public sources (which can be useful for ESG investors and asset managers);
- Specialized data, which consist of firms that provide specialized data on particular ESG issues such as Trucost, which provides environmental data, and RepRisk, which provides information on a firm’s business conduct risk; and
- Rating agencies, that provides the ESG ratings based on the standards set.
|While there have been ESG standards set by the standard setters, there continues to be a lack of ESG reporting standards that are universally accepted. A firm’s own ESG rating may be different from rating agencies due to some differences in their methodologies in arriving to that rating.
Investors must be able to reconcile these differences on their own and practice due diligence in understanding the different methodologies used.
ESG Investing’s Impact on the Investment Landscape
Whether you are a believer or a non-believer of ESG investing, ESG investing is ultimately changing the investment landscape in a variety of ways. For the most part, investment organizations are trying to keep up with the expectations of their investors when it comes to sustainable investing. As a result, their business models and investment models are now revamped and expanded to include the ESG framework.
New Business Model
In general, a business model focuses on the core attributes of investment firms and the way in which they create value and competitive differentiation. As it is their business to achieve the best investor outcomes (i.e. increasing their client’s wealth), new product developments have been made to cater to client demands for ESG products. Such business models need a significant amount of commitment in the part of the investment company in the form of resources, new processes, and incentives to drive such products.
Moreover, the investment firm must be able to operate in such a manner that also reflects sustainability within their own firm before they can actually pull off selling other companies’ sustainability reports to their investors. Therefore, senior management must be able to plan its own sustainability effort, which is founded on the firm’s set of values and beliefs, and extend this into its organizational culture.
The Rise of the Universal Owner
One particular effect of ESG investing is the rise of the universal owner. Universal owners are asset owners with large investment portfolios that essentially make them owners of a portion of the entire economy and the financial market. As the concept of sustainability generally includes corporate and financial stability through ensuring that whatever we do today will not compromise our outcomes tomorrow, sustainable investing is crucial to the implementation of universal owner strategies wherein the overall performance of the future value of an investment portfolio is dependent on the overall economic performance rather than by the return on individual assets or sector exposures.
As it is in the enlightened self-interest of the universal owners wherein they want to achieve well-functioning financial markets and sustainable growth, they will do their best to mitigate the negative effects of externalities that occur when activities of a firm impose a cost on (or provide a benefit to) other firms or the society at large (e.g., pollution). Such externalities can have catastrophic effects on future investment returns, while a buildup of unchecked externalities can result to uncertainty in the investment environment and create greater systemic risks.
Using the ESG framework, universal owners are able to manage their risk exposures to externalities, wherein ESG integration is implemented through active ownership (i.e., stewardship, active engagement). Under the lens of universal ownership, engagement goes way beyond opening a dialogue. Engagement happens when there is an understanding of key issues pertaining to the firm’s sustainable growth and being able to identify key individuals who can create the necessary push for change.
As noted earlier, ESG investing is often scrutinized and judged to be incompatible with the fiduciaries’ legal duties of care, loyalty, and responsibility. However, research findings have come up with a consensus that ESG issues can be consistent with the fulfilment of a fiduciary’s duties and responsibilities.
Interestingly, the rise of ESG investing has also put a lot of pressure on governments to integrate ESG factors, especially in long-term investments like pension funds. As sustainability issues are generally non-financial data, they are not required to be reported. However, investors and experts believe that such information are material to an investor’s decision-making process, hence, the development of key performance indicators (KPIs) that determine the materiality as it related to ESG issues.
In countries like the United Kingdom, Germany, Australia, France, and South Africa, legislations have already been put in place that requires pension funds to disclose how ESG factors are integrated into their investments. Slowly but surely, there will come a time when all firms are expected to disclose information on sustainability issues like climate risk.
This understanding of a more holistic fiduciary culture is practically in alignment with the concept of enlightened self-interest principle in universal ownership as it needs to fulfill the needs of its current beneficiaries without compromising the outcomes for future generations
|Starting this January 12, 2021, the U.S. Department of Labor issued a new ruling which required retirement plan fiduciaries to ONLY consider financial factors when selecting investments, which may be bad news for advocates of ESG investments.
UPDATE: This ruling will no longer be enforced. Instead, DOL plans to coordinate with stakeholders to determine how to incorporate the importance of ESG integration in plan investments while at the same time upholding the fundamental fiduciary obligations.
New Investment Model
The investment model is composed of the thinking and processes that result in the end portfolio like the investment objectives, investment beliefs, a risk management framework, a portfolio construction process, outsourcing, external investment managers, factor exposures, resilience, and stewardship. When it comes to sustainability investments, all these components must consider sustainability in the financial analysis. This way, sustainability is embedded within the investment model and not just regarded as an auxiliary part of the process.
For example, when it comes to investment objectives, you, as an investor, will have financial objectives, which will include the rates of returns, as well as the risks and the time horizons.
A lot of ESG factors are inherent to financial objectives. However, many of these data are not contained in financial statements. Some of the financial materiality may emerge after some time and the ESG factors captured in data are usually classified as an externality. If you are integrating these to your analysis and decisions as an investor, congratulations! You’re already doing integrated ESG investing.
As an investor, you may also have non-financial objectives, which can either be associated with your personal values or with your desire to make an impact with your investments. For example, you may focus on climate change and the carbon footprint of firms. As an investor, you may want to invest in firms with lesser carbon footprints than their competitors or firms that use renewable energy or practice energy efficiency.
More Innovative Financial Instruments
With ESG investing now becoming more popular than ever before, investment firms are finding ways to offer innovative financial instruments. ESG investing is now entering the mainstream phase and it is crucial for investors to have a large enough selection of green securities across all asset classes in order to build ESG-compliant portfolios.
To illustrate, ever since the European Investment Bank issued the first green bond 15 years ago, financial instruments have evolved to include a wider set of sustainable development goals. From sustainability-linked loans to catastrophe bonds and several other green assets, these innovative financial instruments will continue to evolve based on investors’ interest and appetite.
|Sustainable debt issuance (USD billion)|
Source: Henze, 2019 as cited from Uzsoki, 2020
In addition to sustainable debt issuance, there will also be more sustainability-linked instruments for other asset classes like dividends that are linked to the sustainability performance of a firm.
Leaders of ESG Investing: A Closer Look at MSCI, Inc.
MSCI, Inc. is just one of the many investment research firms providing consumers with stock indexes, performance analytics, as well as investment tools and portfolio risk analysis. MSCI Inc. prides itself as the world’s largest provider of ESG indexes with 30 years history of ESG indexes as it strives to bring greater transparency to financial markets, allowing the investment community to make better decisions.
Some of the clients served by MSCI include asset owners, asset managers, banks, and wealth managers.
The following are some of the MSCI ESG Indexes:
- MSCI ESG Leaders Indexes
- MSCI Focus Indexes
- MSCI SRI Indexes
- MSCI ESG Universal Indexes
- MSCI Global ex Tobacco Involvement Indexes
- MSCI Climate Change Indexes
- MSCI Low Carbon Indexes
- MSCI Global Environmental Indexes
- MSCI USA ESG Select Index
- MSCI KLD 400 Social Index
- MSCI ACWI Sustainable Impact Index
- MSCI Fixed Income Indexes
- Bloomberg Fixed Income Indexes
- Bloomberg Barclays MSCI ESG-Weighted
- Bloomberg Barclays MSCI Sustainability Indexes
- Bloomberg Barclays MSCI Socially Responsible (SRI) Indexes
- Bloomberg Barclays MSCI Green Bond Indexes
- Enhanced Focus Indexes
- ESG Screen Indexes
- Custom MSCI ESG Indexes
Equipped with the right solutions (e.g., ESG ratings and data, real estate climate solutions) and transparency tools (e.g., ESG Ratings Corporate Search Tool, ESG Industry Materiality Map, ESG Fund Ratings Search Tool, Index Profile Search Tool) from MSCI, Inc., investors are then able to make better-informed investment decisions.
Final Thoughts on ESG Investments
There is no doubt that ESG investing is here to stay. It’s not just some fad or some niche. It is a new era in the investment landscape that will prompt firms and investment companies to put ESG issues at the forefront of their business and investment models.
The challenge for firms is to adapt to this new investment landscape—clearly one that ultimately favors cleaner, healthier, and smarter products and services. In this new investment landscape, there is no room for backward thinking. It is time to move forward beyond the industrial era when pollution was free, when labor was just a cost factor, and when governance did not even matter.
ESG investing is our “new” normal and we must embrace this. It is something that we should all get excited about. For investors, we get to easily identify firms that will likely last and be able to avoid those that will likely fail. Using ESG, it’s time to vote and use our money for the betterment of humankind.
Disclaimer: The content provided in this article is for informational/educational purposes only, subject to change and is not an investment advice nor is it any offer or solicitation for the purchase or sale of investments.
About the Author Sumit Kumar
Sumit Kumar is a Quant, Investment analyst and Fintech professional working in Capital Market and Financial Technologies for the last 17 years. He is a regular speaker in conferences and webinars in the areas of Derivatives, Risk Management, Capital Market Technology, Financial Systems and Application, Climate Finance, ESG Integration and other social finance issues.
Sumit is also an aspiring researcher on sustainable development, and he is also a Doctoral Scholar at the Indian Institute of Management; Kozhikode (India) and his area of research is around ESG and Climate Finance. He has an MS in Cryogenic Engineering (IIT Kharagpur), MS in Physics (Banaras Hindu University),MBA(Corporate Finance)from IE Business School, Spain.
Currently, Sumit works for THE CERES GROUP as Senior Director – Capital Market, leading Capital Market, Risk , Fintech, Derivatives and Quantitative Finance, ESG Integration Consulting Practice. Sumit is a SME of Systems like Calypso, Murex, Charles River, Risk Metrics etc.