ESG: Road Blocks or the Road to Integration?
Recent international forums such as COP21 and the World Economic Forum (WEF) have drawn increased attention to global economic risks arising from corporate environmental, social and governance (ESG) practices and performance. In particular, WEF concluded that climate change was the greatest global risk in their latest survey1 and made a call to action for ESG integration by investors.
The global drive towards considering ESG factors as core components of business and investment strategies gains momentum year-on-year as it becomes accepted that ESG is relevant and important for sound long term decision making.
What are the road blocks to ESG integration?
ESG integration is not without its perceived challenges by companies and investors alike.
Companies often cite a lack of questions from analysts on quarterly calls as a dis-incentive to disclose further ESG information or to put additional efforts into verifying the data. On the other hand, investors also state the lack of adequate, reliable and consistent disclosure by companies as a hindrance to incorporating ESG.
Some investors have in the past also argued that there is insufficient evidence that ESG adds value and that incorporating these policies may even go against their fiduciary duty to maximize returns to beneficiaries. Are these arguments substantiated or is the reality quite different?
No investor interest?
Contrary to the perception by some companies, there is a growing focus by the largest asset owners and asset managers globally in integrating ESG considerations across all their assets. The Global Sustainable Investment Alliance (GSIA) through its large network of national and regional investment associations has been measuring the size of assets that incorporate ESG factors and in 2014 this represented US$21.4 trillion2, about 30% of professionally managed assets globally, this is up from US$2.6 trillion in 2002. Put another way, seven of the ten largest pension funds in the world are now signatories of the Principles for Responsible Investment and hence now aim to consider ESG factors across all assets.
In analyst calls and meetings the questions may not be termed ‘ESG’, however when there are questions on staff turnover, major industrial accidents or the incentive structure of management, these all relate to ESG factors. The questions and focus may also come from other parts of the investment chain and outside of quarterly result meetings.
Changing benchmarks and passive allocations may also go undetected by companies. It is common for the largest asset owners to integrate ESG factors into their indexes, benchmarks and mandates, for example FTSE Russell now calculates a large number of these custom benchmarks for its clients. Companies will often be oblivious to these benchmarks and index tracking funds whilst the questions from brokers and analysts catch their attention.
Against fiduciary duty?
In the past there was much confusion between what is ‘ethical investment’ and ESG integration into investments. Linked to this, asset managers and advisers have often cited fiduciary duty as a reason for not incorporating ESG factors into the investment decision-making process; claiming non-financial indicators were not investment relevant and instead only reflected particular people’s personal values.
Recent studies have broadened the interpretation of fiduciary duty and have emphasized that there is no intrinsic conflict between fiduciary duty and ESG considerations. Despite these outdated perceptions continuing to exist in significant pockets of the investment industry there is a generally accepted recognition that ESG issues are investment relevant and therefore should be considered by fiduciaries. In some markets this is being clarified by regulators and those providing market oversight.
The 2015 UK Law Commission’s Report on the fiduciary duties of investment intermediaries found that consideration of environmental, social and governance factors by pension trustees was entirely consistent with their fiduciary duty to beneficiaries. This position was also endorsed in the United States following an October 2015 revision to the Employee Retirement Income Security Act (ERISA). Enacted in 1974, ERISA sets out minimum standards for private sector pension and health schemes in the U.S. One key issue is the definition of a scheme’s fiduciary duty. Following this change the law now considers that ESG integration is not at odds with a pension scheme’s fiduciary duty.
This position is also reinforced through the development of Stewardship Codes that encourage investors to deepen their interaction and engagement with investee companies on strategic issues. The UK Stewardship Code was first unveiled in 2010 by the Financial Reporting Council and other Stewardship Codes have since been adopted in a variety of other countries including South Africa, Switzerland, Italy, Holland, Japan and Malaysia, influenced by the UK version. A key component of these Codes is to enhance constructive engagement on issues including how the investee company addresses risks arising from social and environmental matters, or governance.
Beyond the obstacles: the road to integration
In order to support the growing interest in ESG the most crucial challenge facing participants is to understand what ESG information should be considered as part of the investment decision making process and how to interpret it.
There are two different lenses to evaluate and assess a company. First, there is the ESG approach which focuses on a company’s operational activities and how well they address the specific ESG risks to which the company is most exposed. Secondly, the Low Carbon Economy (LCE) approach focuses on the source of a company’s revenues and if it contributes positively to a low carbon economy.
Applying an ESG framework
The integration of ESG data into investment processes places increased importance on the availability, consistency and reliability of the information provided by companies. FTSE Russell helps drive the alignment of standards globally, for the benefit of investors and companies, by drawing from the leading international standards and frameworks for each ‘ESG Theme’ for which companies are evaluated. The FTSE Russell ESG framework has a strong focus on the identification of material themes so that the methodology becomes tailored for each company evaluated.
FTSE Russell’s ESG Ratings can assist the investment process in several ways, including:
- Engagement and Stewardship: Identifying companies with high exposure and low scores which could mean that a company is facing business risks from not managing material ‘ESG Themes’
- Integration into active investment decisions: Identifying factors considered alongside other fundamental data
- As a basis for ESG indexes: This can be either one of FTSE Russell’s current indexes such as the FTSE4Good Global Index or on a custom basis
- Manager selection and evaluation: Asset owners such as pension funds use the data to provide insights on the ESG characteristics of portfolios from current or potential fund managers
ESG trends in Developed Markets
The next chart shows the average ESG Rating of different countries represented as the average of their companies’ Ratings. Although FTSE Russell is researching a large number of countries, for simplicity the chart focuses only on the largest markets. Europe, Australia, Canada and the U.S. come out on top whilst the Asian markets come out below the average of all eleven developed markets.
ESG investing is here to stay
There is growing momentum across capital markets to seek and consider ESG data within core investment strategies. In some markets this is more developed than in others, and some institutions are approaching this at a deeper and more sophisticated level than others but the direction of travel is very clear. Investors also have a strong incentive to encourage companies to enhance their ESG disclosure.
ESG factors can relate to individual values but many investors are now using ESG to seek long term investment value.
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1 World Economic Forum, Global Risks 2015 Report, http://reports.weforum.org/global-risks-2015/
2 Global Sustainable Investment Alliance, Global Sustainable Investment Review 2014 http://www.gsi-alliance.org/wp-content/uploads/2015/02/GSIA_Review_download.pdf