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Getting to the bottom of ESG

04 September 2020

8 minute read

By Damian Payiatakis, London UK, Head of Impact Investing and Olivia Nyikos, London UK, Investment Strategist

The increased popularity of sustainable investing, and its encouraging performance, seen in a period of extreme volatility this year may mark a turning point. But what marks this form of investing out and why should Environmental, Social and Governance (ESG) practices be considered when constructing their portfolios?

As COVID-19 disrupted markets in the first few months of the year, billions of dollars flew out of conventional funds. In contrast, those targeting positive environmental and social outcomes kept attracting converts. For instance, investors allocated $45.6bn to sustainable-focused funds in the first three months of the year, when global outflows reached $384.7bn for the overall fund universe.

At the same time, sustainable strategies predominantly outperformed during this period (see chart).  Separate analysis found that the majority sustainable indices outperformed their broad market peers.

Adding value

Underlying the increased capital inflows and favourable investment returns to sustainable-focused funds is a growing realisation of the value of sustainable strategies and the consideration of companies with strong ESG practices. Sustainability is becoming a key driver for financial returns. Companies with more effective operating practices may be more likely to create value and perform better in the long run.

Various research shows that companies that are environmentally conscious, are socially responsible and uphold good governance tend to have higher profitability and valuations with less market sensitivity and lower tail risk than other companies. Alongside financial strength, arguably companies with a more flexible approach to production, human capital practices and corporate governance may be able to better navigate volatile periods than those that don’t.

When examining performance, better sustainability practices, management of ESG risk and forward-looking opportunities often account for much of the added performance attributed to sustainability investing. As more non-financial information is reported by companies, investors should be better positioned to identify more resilient and effective companies during the crisis.

ESG data and ratings

Signatories of the UN sponsored Principles of Responsible Investment, which covers $90 trillion of assets, commit to take into account companies’ operating practices – including environmental, social and governance – in their investment decisions.

The core premise is that by considering ESG factors, an investor can take account of a broader set of data and so can make a better judgement about the financial performance and longer term value of a company (see table). In essence, ESG credentials aren’t only an important source of information, but can also help identify material financial risks that could affect the reason for investing in a company or group of companies.

Environmental, Social, Governance (ESG)

  • Environmental considerations relate to the quality and functioning of the natural environment and natural systems
  • Social considerations relate to the rights, well-being and interests of people and communities
  • Governance considerations relate to the governance practices of companies and other investee entities.
Environment Social Governance
Carbon emissions Labour management Corporate governance
Energy efficiency Diversity and discrimination Business ethics
Natural resource use Working conditions Anti-competitive practices
Hazardous waste management Employee safety Corruptions and instability
Recyclyed material use Product safety Anti-bribery policy
Clean technology Fair trade products Anti-money laundering policy
Green buildings Advertising ethics Compensation disclosure
Biodiversity Human rights policy Gender diversity of board

To support these assessments, data firms and ratings agencies collect and report on ESG data, which focuses primarily on how a company operates. The comprehensive set of raw data points is based on publicly available sources such as annual reports, company websites, sustainability reports or contributed by surveys. Once audited and standardised, this data can help to reveal the impact that companies are making in absolute terms (such as carbon emissions generated), or relative to peers (perhaps for gender diversity of a board make-up relative to peers).

Armed with awareness

Data providers play an important role in the investment process by gathering and assessing information about companies’ ESG practices and then scoring those companies accordingly. The development of such ratings systems has helped the growth of sustainable investing by helping investors to conduct due diligence.

As data providers generally develop their own sourcing, research and scoring methodologies, the rating for a company can vary across different providers. These differing methodologies also have implications for investors. In choosing a particular provider, investors are, essentially, aligning themselves with that provider’s ESG investment philosophy in terms of data acquisition and methodology – including materiality, aggregation and weighting.

The lack of standardisation and transparency is driven partially by data quality – the lifeblood of investment analysis. Many agree that consistency and comparability in the availability of data across companies are essential elements of an effective data set. Yet, companies that wish to report on their ESG credentials have a myriad frameworks to choose from. The most commonly cited frameworks are:

  • The Sustainability Accounting Standards Board (SASB)
  • Recommendations of the Task Force for Climate-Related Financial Disclosures (TCFD)
  • Global Reporting Initiative (GRI)
  • UN Sustainable Development Goals (SDGs)

Finding a standardised solution

Investors would prefer the same metrics across all companies for ease of comparability, as well as to establish benchmarks and find trends. From a company’s perspective, a likely preferred framework would be one that can be used as a consistent and repeatable framework. One that can take account of investor priorities and the transparency and accountability that regulators expect from companies in the long term.

With sustainable investing becoming more popular, solutions and new approaches are being adopted. In response to the variation across some ratings, investors may attempt to identify the ‘best’ among the providers, use an aggregate score based on a number of providers or develop their own set of metrics. Some, in addition to the level of ESG scores, explicitly incorporate the dispersion in the ratings into their investment processes. On the standardisation and transparency side, guidance from investors and regulators on their preferred method is increasing with various parties pushing to standardised ESG reporting.

Despite the shortcomings in standardisation and transparency in providers’ data collection and scoring methodologies, these providers have made valuable contributions in advancing ESG investing globally. Investors who understand some of the limitations of this data, could learn to manage and mitigate key risks and opportunities better.

ESG and portfolio construction

With the attractions of sustainable investing seemingly on the rise, more investors appear to be using environmental, social, and governance data and ratings to inform their decision-making.

ESG integration into the investment process allows investors to understand the complexities of identifying associated risks and opportunities. As such, investors can position themselves to manage the risks and opportunities associated with these new paradigms.

Even though the use of ESG data and ratings is still in its infancy, and the concept of sustainability is by nature a fluid one; the underlying premise is that investment decisions should factor in the impact of how companies operate. The benefit of using ESG criteria to determine the security and value of investments are now widely acknowledged.

Still, the usual caveats for performance must be acknowledged. There are various routes to integrate ESG factors to enhance investment decision-making, with increased depth and sophistication. It is also important to note that just as financial data is not perfect, non-financial data will never be so either. Furthermore, not all sustainable investors use the same approach, or have the same skills, resources or senior buy-in and support to make integration core to the investment philosophy.

Making a positive difference

For all the difficulties, ESG integration equips investors with more tools that can be used to build portfolios that beyond aiming to be profitable in the long-term, may help make a positive difference to the world.

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Market Perspectives September 2020

Financial markets are in fairly upbeat mood. That said, sentiment appears fragile while the focus of investors is on pandemic developments.

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