Advisors who fail to understand the growing popularity of investing according to environmental, social and governance (ESG) principles risk falling behind their competition. According to two recent studies — one by the CFA Institute and the other from Cerulli Associates — ESG factors are becoming increasingly important for investment professionals and their clients.
Seventy-four percent of investment managers take ESG factors into account when making investment decisions, and risk management is the single most important reason why, Cerulli said in its November Cerulli Edge report.
The CFA Institute’s recently published ESG Guide for Investment Professionals showed similar results: 73% of survey respondents consider ESG issues when making investment decisions and 63% did so to help manage investment risks. (Forty-four percent consider ESG issues because their clients demand it). Also, Bloomberg has reported that the number of customers using ESG data in 2014 grew 76% from the prior year and swelled by more than 600% since 2009.
“All financial professionals, whether they’re financial advisors, hedge fund managers or institutional investors, are doing themselves and their clients a better service by understanding these issues," Matt Orsagh, director of capital markets policy at the CFA Institute, told ThinkAdvisor.
The corollary is also true: Those who don’t consider ESG factors are doing themselves and their clients a disservice. They’re more likely to miss something in their analysis, Orsagh said.
Contrary to popular belief, ESG issues are relevant not only for equity investments but also for fixed income assets because they can affect creditworthiness, according to the CFA Institute.
The London-based mining company Lonmin (LMI.LN), for example, issued a warning in 2012 about servicing its debt following labor conflict in Marikana, South Africa. “Risks pertaining to social issues, which could easily be overlooked in a traditional financial analysis, could also prove costly for fixed-income investors,” according to the CFA Institute report.
ESG factors are also the inspiration for green bonds, which invest in environmental projects, and social impact bonds, whose proceeds pay for projects or services that improve social outcomes.
According to the CFA guide, corporate governance is the most analyzed of ESG issues for stocks and bond investments, followed by environmental and social issues (such as labor practices).
Cerulli reports that clean technology and renewable energy, however, are the most followed ESG themes among mutual fund managers.
ESG investing generally falls into two categories: one that excludes companies based on the products they produce (alcohol, tobacco, oil) or practices they follow (regarding labor and human rights, for example) and one that includes companies based on best ESG practices, such as companies that are more energy efficient and reduce carbon emissions or companies that closely monitor working conditions at all the factories in their supply chains.
Exclusionary screening is the oldest ESG method but no longer the most popular, according to the CFA Institute. “Investors are taking a more holistic view integrating ESG into the investment process,” said Orsagh. But beyond these two approaches things get complicated. Here are some of the reasons why.
- “There is no one exhaustive list of ESG issues,” according to the CFA Institute report. “ESG issues are often interlinked, and it can be challenging to classify an ESG issues issue as only an environmental, social or governance issue.”
- “There is a lack of consistency in the use of [ESG] labels and different labels can be used to mean overlapping ideas,” according to the CFA report. For example, “socially responsible investing” and “sustainable investing” are often are often used interchangeably but not necessarily understood to be same thing.
- ESG issues do not fit well with the short-term investing metrics such as analysis of quarterly earnings that dominate everyday financial markets.
- Measurements of ESG investing vary globally. Although the United Nations–supported Principles for Responsible Investment (PRI) is the principal framework for investors considering ESG, there are multiple principles, standards and conventions that investors use, according to the report, and it’s never easy comparing apples with oranges. Here’s just a partial list: UN Global Compact, Equator Principles, OECD Guidelines for Multinational Enterprises, International Labor Organization Declaration on Fundamental Principles and Rights at Work, SA 8000 (auditable social certification standards for decent workplaces), and ISO 26000 (guidance on how businesses can operate in a socially responsible way).
- There are also are multiple organizations around the world working to promote ESG considerations for investing purposes including the Global Sustainable Investment Alliance (including USSIF and Eurosif), Global Reporting Initiative, Sustainability Accounting Standards Board, and World Resources Institute.
- There are scores of laws and regulations pertaining to ESG issues already in place around the world, with more coming, requiring different levels of disclosure. A 2013 study by KPMG, the Centre for Corporate Governance in Africa, the Global Reporting Initiative and UNEP stated that there are 180 laws and regulatory standards in 45 countries pertaining to corporate sustainability reporting and 72% of them are mandatory, according to the CFA Institute report.
“These are early days,” said Orsagh. “These issues are still being sorted out.” He expects the market will eventually work out these differences over time. In the meantime, Orsagh said, “Companies that are more transparent will gain more trust of investors,” and those that are less transparent may suffer “detrimental effects.”
In the meantime, advisors can use a tool from Barclays to gauge how important ESG issues are to their clients, and Bloomberg and other data providers provide information about companies’ ESG policies, if any. “Data providers and standards differ depending on industry and more,” and “different markets have different standards that are required,” said Orsagh. One development that he's watching is the Sustainable Stock Exchanges Initiative, a peer-to-peer learning platform for stock exchanges and regulators to share best practices concerning ESG issues.
Many global stock exchanges have signed on as partner exchanges of the initiative including the New York Stock Exchange, but few require companies to provide comprehensive disclosure on ESG issues in order to be listed. Among the exceptions are the Australian Stock Exchange (ASX), which recommends that companies disclose and identify how they intend to manage environmental and social sustainability risks, and the Johannesburg Stock Exchange (JSE) in South Africa which expects all issuers to disclose how they have addressed the principles set out in the King Code of Corporate Governance or why they haven’t.
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