ESG - the benefits, challenges, and sustainable investment trends
The challenges of integrating ESG themes and data in the investment management process
This article provides a high-level industry overview of ESG (environmental, social, governance) realities and challenges, including a recap of some of the major market events that have made the topic of ESG mainstream, a description of the main aspirations behind ESG, and, finally, current market trends and the goals and challenges of implementing ESG in the investment management industry.
ESG is an increasingly prominent theme in the investment management industry. We are probably all familiar with recent scandals connected to environmental, social, and governance related topics. Similarly, investors are familiar with the consequent price movements of the corresponding securities involved in the scandals. At the same time, asset managers have been active in launching and servicing a range of innovative ESG products.
ESG in brief – background and recent scandals
Not long ago, we have seen the CEO of McDonald’s lose his job for having violated the company’s code of conduct after his affair with an employee was unveiled. Companies, especially in the US, have become intolerant to personal relationships between executives and employees. The issue has never been the deed itself, but rather its implications. Ultimately, it is hard to distinguish an innocent relationship from the one that exploits the power structure in a corporation. This attitude reflects the unwillingness of investors to take risks related to governance and conflict of interests.
In recent years, investors have proven to be intolerant to scandals related to environmental, social, or governance matters. Most readers would be familiar with the Diesel scandal, even without having to mention the name of the involved company (See Figure 1).
Similarly, data-leaks and attempts of influencing elections remind us of the data scandal with Cambridge Analytica. In both cases, the respective shares of Volkswagen Group and Facebook, Inc. fell more than 20% in a single trading day (See Figure 2). This is the definition of a drawdown, usually perceived as an unlikely tail event, hitting the investors’ portfolios hard.
What is ESG?
The Universal Declaration of Human Rights dates back to the year 1948. “A common standard of achievements for all peoples and all nations. It sets out, for the first time, fundamental human rights to be universally protected”, it says about the declaration on the United Nations website.1 Taking a more practical approach, the United Nations has in recent years set 16 Sustainable Development Goals (SDGs), recently adding the 17th goal, Partnerships (See Figure 3). The SDGs aim to align its concrete targets with the Universal Declaration of Human Rights in terms of rights and livability on the planet. Based on the SDGs, a group of CEOs around the world has started an initiative to help facilitate the implementation of the universal principles of the SDGs, which has resulted in the UN Global Compact commitment. The UN Global Compact covers four areas and specifies commitments within each of them:
Human Rights under which the companies are expected to respect the universal declaration and the United Nations treaties such as the prohibition of nuclear or mass destruction weapons.
Environment under which the companies should take precautionary measures to avoid environmental disasters and encourage environmental friendly technologies.
Labor under which the companies should ensure respectful business practices and a solid code of conduct.
Anti-corruption under which companies enforce the compliance to a solid corporate governance to promote transparency and fairness.
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More recently, governments and companies have committed to the COP 21 agreement, which has the purpose to curb CO2 emissions as a tangible objective towards slowing down the global warming. From an ESG perspective, the agreement stipulates that companies must report mandatory information and estimates of their CO2 emissions, and further, companies in high CO2 emitting industries are expected to report their transition strategies for reaching a lower CO2 emission level. However, the scoring is highly subjective as it is hard to accurately predict the optimal CO2 level or saving potential in a certain industry, not to mention the inability to measure the CO2 impact of the transformation strategies.
In terms of standards applied by companies, an ISO standard regarding GHG (Green House Gas) defines three scopes of emissions as follows:2
Scope 1: Direct emission from owned and controlled resources.
Scope 2: Indirect emissions from purchased energy.
Scope 3: Indirect emissions that occur in the value chain.
How can companies create value from applying ESG metrics?3
A number of benefits can be achieved by applying ESG metrics and setting goals for business practices:
A better corporate governance leads generally to better employees retention and engagement.
Reducing the consumption of the resources that are part of the value chain reduces the direct operating costs. However, it might first take an investment in changing the way product or services are produced to achieve this cost reduction.
Reducing the indirect polluting behavior has a direct effect on the SG&A costs.
Having weak internal standards can lead to more compliance investigations or audits, naturally coming with a cumulative financial impact.
Finally, millennials are increasingly interested in the impact of their consumption. In other words, taking an ESG approach can lead to an organic growth of the top line!
Impact investment - why is it hard to agree on a SRI theme?
Socially responsible investment (SRI) refers to investments with a positive impact on society, and we have seen SRI investments related to various social causes flourish in the investment management industry. Yet, what can be defined as a “good” action is not the same to everybody. Socially responsible investments have been numerous, spanning from investing in funds respecting the Catholic principles, over investing in green energy power plants and water technology platforms, to plastic and waste reduction technologies, and gender gap. The list can go on. The choice of SRI theme is indeed a personal preference rather than a matter of scientific approach. The investor has to find a way to align her or his personal interest with the right and relevant investment product.
What are the main trends in ESG investments?
According to Morningstar research, the share of ESG investment in Europe has been growing fast for the last decade. In 2014, the AUM of ESG funds was around USD 200 billion and it has since gone up to around USD 600 billion in 2019. ESG investments are unevenly distributed when it comes to investment style, such that passive investments comprise only one sixth of those of the active style. Nonetheless, the recent months have seen a boom in the number of ESG benchmarks and many providers have launched an ESG version of their core investment offerings (See Figure 4).
The total US domiciled AUM using sustainable, responsible, and impact strategies grew from USD 8.7 trillion at the start of 2016 to USD 12 trillion at the start of 2018. How valid are these numbers? How scientific is the construction methodologies behind these funds? No one can tell.6
Beyond AUMs, what has also changed?
ESG integration in daily investment management processes has also implied that certain organizational changes have taken place. According to a survey by the ‘SimCorp ESSEC - Observatory for Investment Management‘4, 92% of the respondents confirmed to have an internal team dedicated to defining, implementing, and monitoring their ESG strategy (See Figure 5). This finding indicates that the companies surveyed do not want to fully rely on the available of-the-shelf ESG data. Roughly 50% of the respondents confirmed to be utilizing both internally or externally generated data points.
Sofia Ramos, Professor of finance at ESSEC Business School, confirms the mentioned trends and gives us her personal perspective: “We expect ESG to continue to significantly grow in the future. Key challenges for asset managers will be to cope with large volumes of extra financial data and integrate them in standard valuation models to make the most informed investment decisions. Adjustment of valuation models and their calibration to the new data is going to be key."
ESG in practice in investment management
The interpretation of the fiduciary duty of an asset manager has and will be evolving. More and more investors are interested either in understanding the impact of their respective investments on the environment, society, or human rights, or in the impact of integrating ESG on their corresponding investment performance.
In both cases, this leads the institutional investors to consider the following:5
Improve the ESG reporting and climate-related risks reporting in relation to their portfolios or funds.
Align their internal governance according to the adopted principles.
Adjust the investment strategy workflows and/or enhance the risk management processes.
The latter point would require a series of steps such as:
Sourcing data internally or externally from various providers.
Analyzing the coverage of this data.
Setting a selection strategy depending on the quality of the coverage.
Integrating the data within the enterprise asset management system at the level of the compliance management, portfolio management or reporting.
The need for external data, particularly to have a comprehensive coverage, is unavoidable. Asset managers should develop a thorough due diligence process to understand the providers’ methodologies and quality of work. For example, an asset manager should ask whether the data is based on publicly available corporate reports, media sources, or proprietary on-site investigations. A fair share of the information can be hidden in the supply chain especially in countries lacking the appropriate reporting and/or regulatory frameworks.
Furthermore, depending on the investment universe, an asset manager should define the geographies and industries of interest.
The ESG industry has never played a more serious role in the investment management industry than it does today. In this regard, the non-financial data involved should be treated with the same respect as financial data. In particular, because it looks as if the days of non-audited ESG reports are soon over. With the increasing impact of ESG data, the respective reports issued by companies will be verified and audited just as financial reports in the future.
Eventually, the best way an investor can make sure that the ESG goals set by a company are achieved is by exercising the voting rights that he/she is entitled to. Investors have to play a more active role to influence a company’s governance and to create a positive impact. Consequently, the corresponding asset managers should be able to have a holistic view of the underlying ownerships and voting rights in their portfolios, and more importantly, exercise this right.
EU Taxonomy technical working report has been published. The purpose of this regulation is the following:
Create a common European framework for understanding the sustainability topic – in particular the impact of business activities on the climate change - and setting the required standards for a successful adoption.
The report categorizes financing activities to depict those with a positive contribution to the climate change mitigation and/or the climate change adaptation.
The report defines the relevant users of the taxonomy and the relevant use cases, such as the companies required to report sustainability data and financial institutions that are expected to utilize the reports.
The report describes the economic impact of this potential regulation and the costs of transmission.
The report classifies business activities in the categories of Climate Change Mitigation and Climate Change adaptation by creating a mapping from the NACE classification.
The report lists potential relevant data point to report.
In the EU as well, the Climate Benchmarks and Benchmarks ESG Disclosures working report has been published covering the following:
“The minimum requirements to create a climate benchmark.”
“Technical advice on ESG disclosures, including associated disclosure templates.”
The aim of the EU Paris-Aligned Benchmarklabel is to align the objectives of the climate benchmarks with the COP21 agreement.
The aim of the EU Climate Transition Benchmark label is to monitor and enforce the CO2 intensity reduction by members of a benchmark, having an objective a climate transition strategy.
In the US, several acts are of relevance to the topic:
ESG Disclosure Simplification Act of 2019 [DRAFT], H.R. __, 116th Congress (2018-2019)
Shareholder Protection Act of 2019 [DRAFT], H.R. __, 116th Congress (2018-2019).
Corporate Human Rights Risk Assessment, Prevention, and Mitigation Act of 2019 [DRAFT], H.R.__, 116th Congress (2018-2019).
Climate Risk Disclosure Act of 2019 [DRAFT], H. R. 3623, 116th Congress (2018-2019).
In the latest review, the congress has rejected the proposed standards in point 1.
In the UK, the government issued a draft on the Green Finance Strategy to regulate the disclosure of climate-related risks as of 2022.