The ESG spring has joined the main stream
It is clear that ESG awareness and implementation are becoming widespread across the investment industry. Funds managed by signatories to the UN Principles of Responsible Investment have passed $60tn, amounting to more than 50% of invested assets worldwide. The majority of high-net-worth individual investors now seek more ESG disclosures from their wealth managers, with those under the age of 40 the most demanding, according to the World Wealth Report 2015. National governments, notably China’s, are employing environmental finance, using instruments such as green bonds, as they aim to reduce the carbon intensity of their economies. Public policy and regulation, such as the French law requiring asset owners to disclose how they are assessing carbon risk, also focus investors’ attention on sustainability matters.
In turn, companies are being asked for better disclosure of their governance practices and how they consider the environmental and social impacts of their operations. The updated UK corporate governance code, issued in September last year by the Financial Reporting Council, stresses the need for company boards to consider strategy with a view that extends beyond a minimum of 12 months. Emphasising the disclosure of principal risks, the code aims to improve transparency under a comply-or-explain framework. In February the London Stock Exchange Group released “Revealing the full picture: Your guide to ESG reporting”, which provides guidance on addressing ESG considerations in investor reporting and communications.
Investors are also being provided with guides that encourage them to assess the ESG merits of companies. The Principles for Positive Impact Finance are designed to help investors understand and monitor the ESG impacts of their activities (see figure 2). Released in January by the UN Environment Programme – Finance Initiative, they constitute a direct response to the challenge of aligning investment practise with ESG pull factor of the SDGs.
Methods for integrating sustainability characteristics into investment decisions are also available to a broad range of investors, rather than being the domain of specialists. In early 2016, Standard & Poor’s launched an index consisting of companies with the potential to create long-term value based on financial quality and sustainability criteria. With asset owners in mind, global investment consultant Willis Towers Watson has created a framework for a long-term mandate, with a structure and incentives promoting a focus on time horizons expanding up to 10 years.
Such efforts are supported by consistent improvements in the quality of ESG data reported by companies. So far, the depth of information provided on corporate governance typically outweighs disclosures on environmental and social matters. Our research indicates that a persistent ‘governance premium’ amounting to 30bps each month can be captured by avoiding the worst-governed companies in the global equity universe1. We have identified some evidence of a link between good environmental and social risk management and returns, but there is not yet enough meaningful and timely data to provide a statistically significant result.
But as more companies continue to report on these matters, and a longer history of data is compiled, we expect to see environmental and social factors to be confirmed as influential drivers of return.
Seeing the SDGs in an investment context
The aim of ESG integration is to avoid businesses with unsustainable risks, which compromise their long-term revenues, and identify those that are embracing sustainability dynamics to enhance profitability. For companies to achieve long-term success, we believe it is essential for them to commit to responsible business practices and build trusting relationships with all stakeholders while skilfully executing superb corporate strategies.
In an investment context, the SDGs direct capital towards companies whose activities contribute to positive economic, social and environmental impacts. Since the themes captured in the SDGs – such as good health and well-being, affordable and clean energy and sustainable cities and communities – address fundamental challenges that society is grappling with, companies involved in providing solutions are likely to benefit from sustainable cash flows and be attractive long-term investment opportunities.
Many companies, regardless of sector, have some exposure to the SDGs. Even chemical companies are starting to report on revenue earned from environmentally beneficial products. Considering the SDGs, therefore, does not penalise investors by restricting the range of stocks available to them.
We aim to invest in companies that generate strong, sustainable returns and which are experiencing positive change. Analysing ESG considerations is a fundamental part of what we do – we see it as a way to manage risk and to improve returns, and the SDGs provide a complementary framework for targeting companies that fulfil these criteria.
MSCI ESG Research has created a data set for investing in alignment with the SDGs. The index provider assesses the percentage of revenue that companies earn from activities supporting relevant environmental and social themes (see figure 3). It shows that while the revenues of 934 companies have some alignment with the SDGs, this number almost halves to 487 if a 10% revenue threshold is introduced. And at a 20% threshold, 303 companies are tracked. But like most ESG data, MSCI’s is retrospective and refreshed annually, meaning that it only presents half of the picture.