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Why investors are moving on ESG

25 February 2021 |
Active ESG
Eoin Murray, Head of Investment, takes a trip down memory lane and into the future with ESG...

Every journey begins with a single step.

The well-trod quote, often attributed to Confucius, actually belongs to contemporaneous Chinese philosopher Laozi.

More usually, the translated Laozi maxim sets a 1,000-mile limit on the notional trip, but I prefer the open-ended version. Sometimes we must begin without quite knowing how far to journey’s-end, or even if there is one.

It certainly seemed that way almost 40 years ago when a predecessor entity of Federated Hermes took the first step into the space we now know as environmental, social and governance (ESG) investing.

But in 1983 when the late Ralph Quartano, chief executive of the just-established PosTel Investment Management, strode out to challenge the Marks & Spencer board over ‘special’ loans to directors, there was no ESG  – or any of the host of other pseudonyms including sustainable, responsible and ethical that this ‘socially conscious’ style of investing has since been tagged.

Quartano was simply doing the right thing by the PosTel investors. Under his leadership, PosTel, which later evolved into Hermes Investment Management and now the international business of Federated Hermes, may have helped begin the ESG journey but for a long time it was a road-less-travelled.

Until relatively recently, ESG was a niche concern for a small group of investors who correctly saw that responsible allocators of capital must look beyond the bottom-line financials for a broader understanding of return, and risk.

Further on down the road

We have come a long way since Quartano first put his foot forward on the responsible investment path in 1983.

Along the way the international business of Federated Hermes has passed some important milestones including the establishment of our stewardship arm, EOS at Federated Hermes (EOS), in 2004 and helping draft the UN Principles for Responsible Investment (PRI) in 2006.

And the road for ESG investors is today more like a busy highway than a lonely backcountry lane.

According to some measures, as at the end of 2020 more than $40tn is now in ESG-aligned investments while about 40% of managers make some claim to responsible (or the like) credentials.

Investment managers have responded to the demand for ESG strategies from asset owners including pension funds by developing a swathe of product offerings that sit on a spectrum of priority in terms of the returns to society.

In some sense this suggests that we have progressed from a narrow view in which only pure financial metrics, derived from traditional balance sheet, P&L, or cash flow statement, mattered, to a world in which we take a more holistic view of financial returns.

Just a few years ago a consultant friend told me that under 200 funds in their investment universe were classified as responsible or sustainable: now the same ESG product subset is numbered in the thousands.

Of course, this growth represents genuine progress, but it also includes some instances of re-labelling without underlying change, a practice known as ‘green-washing’.

Green-washing aside, the ESG trend is now undeniably an accelerating trend that all investment managers must front-foot or risk being left behind.

Picking up the pace: four reasons why ESG is now the way

But what is driving the responsible investment boom?

The Covid-19 health and economic crisis has clearly been influential in the short term – boosting demand for ESG investment framed around social issues, in particular.

Furthermore, the pandemic has likely laid bare for investors the longer-term climate, biodiversity and ecosystem challenges facing humanity.

ESG investing, though, rests on four fundamental forces that have operated independently of any short-term crisis such as the coronavirus outbreak.

First, reputation is now a key motivation for corporates, with beneficiaries focused on their moral stance and ethical beliefs.

Back in the ‘90s this movement started with protests against the then apartheid regime South Africa; later tobacco came under the spotlight; and subsequently, numerous UN conventions highlighted certain repugnant activities (such as cluster bomb munitions) for investors to avoid.

Secondly, investors have become increasingly aware that there are risks associated with ESG factors that must be taken into account. In climate change terms, we group these into physical, transitional and societal. We know the necessary reduction in the use of fossil fuels required for the survival of life-as-we-know-it will lead to stranded assets, for example – and we must accept this.

Thirdly, the canny investor sensed an opportunity – and with one eye to the future, a link was made between longer-term financial returns and matters of sustainability. The current pandemic, where the most resilient companies have clearly performed better, has validated this point.

Lastly, the seers of our industry spotted the wider impact of their actions, understanding that in a world where there are explicit planetary boundaries, a social licence to operate matters.

Walking past performance: stewardship and the sustainable future

The ESG movement has been helped, too, by a growing body of evidence correlating responsible investing with better risk-adjusted returns.

For instance, our latest research ‘ESG investing: how Covid-19 accelerated the social awakening’ reiterated earlier studies that found statistically significant evidence of outperformance across the social and governance factors.

Academics are also making the connection between investment outperformance and effective asset stewardship. In fact, we believe that investment is actually two activities rolled into one, namely:

  • allocating capital; and,
  • being a good long-term steward of that capital.

Stewardship is the less well-known and understood component of investing but – for the international business of Federated Hermes, at least – it stands equally as important as selecting the right assets in the first place.

Being a good steward of capital does not solely involve voting your proxy. There is far more to it than that.

While there is no one-size-fits-all approach to stewardship and corporate engagement, it is a process that we take very seriously with a team of highly experienced investment professionals who work with dedicated engagers and/or engagement professionals from EOS.

At the beginning of each year, we work with our clients, many of them pension funds, and together with the investment floor, we come up with a set of desired engagement objectives for the coming year. We set goals for each one, and then measure ourselves against those goals. We may have different levels of engagement depending on how serious a particular issue being tackled is. And then throughout the year, we will adjust that plan as new material issues surface.

Many of our engagement targets are aligned with the UN Sustainable Development Goals (SDGs), which are rapidly emerging as the go-to framework for holding companies to account on specific, practical outcomes.

Again, our engagement process is embedded across asset classes and can play out over long periods of time with successes mounting up incrementally.

We have also developed a range of tools that we use ourselves on the investment floor and that we can share with clients to help them assess how effective our ESG and engagement integration is. And as we turn our minds to issues beyond climate change, we will continue to develop additional tools in the sphere of biodiversity and ecosystem loss for example.

New directions: where regulations are pointing

We believe ESG is an essential component of investment fiduciary obligations – a view increasingly reflected in regulations.

Governments are pushing both for investment firms to take ESG into consideration at a high level and for better granular data to improve implementation.

Although disclosure of ESG information has been improving globally, there is still far too much variability. This is an invitation to regulators to step in, and indeed that is what is happening.

The EU will keep us busy with sustainability-related disclosures and the Non-financial Reporting Directive based on its Taxonomy.

In the UK, TCFD-aligned information moves to a comply-or-explain regime in June this year. Other jurisdictions including India and Thailand have similar ESG reporting regulations in train.

Meanwhile, new US President Joe Biden has reset the agenda for responsible investment, starting with a return to the Paris Agreement on Climate Change.

Change is coming too for the accounting industry. The IFRS Foundation, the body that oversees the work of the International Accounting Standards Board (IASB), is proposing setting up a parallel Sustainability Standards Board – if it comes to fruition, the SSB would make it possible for the holy grail of integrated reporting to be achieved, where the relationship between strict financial performance is clearly linked to sustainability outcomes.

There are many more examples. This regulation is necessary because we have been too slow to agree upon and set minimum standards – but I worry about unintended consequences. I fear that a ratings and labels industry will rise on the back of legislation that will not meet its intended purpose.

Next steps for investors: how active choices can achieve real goals

From my perspective, however, the truly interesting commercial question revolves around which parts of ESG can or should sit alongside active management and which fit better with passive approaches.

I believe that use of backward-looking, historical ESG data lends itself well to a passive approach – and there may be scope for systematic players to forecast forward such information. But the active industry can justify its worth in superior understanding of ESG information and the genuine application of stewardship.

ESG investors also need to diversify beyond the climate crisis: it is ESG, not CSG after all. We face multiple ‘E’ problems including biodiversity and ecosystem loss, intertwined with the climate crisis, that the investment industry must address: doing nothing is simply not an option.

But we have tools at our disposal, and their time has come. Take the world of fixed income – green bonds are steadily becoming a feature and their issuance grew considerably in 2020.

Putting project-related instruments to one side, sustainability-linked bonds that relate interest payments to outcomes against pre-specified ESG targets must be the way forward.

In the investment industry we have huge responsibilities for the capital that we manage to the end beneficiaries that have entrusted us. Huge challenges lie ahead, and to tackle climate change and biodiversity and ecosystem loss, we need a systemic view.

From the distance of 2,500 years or so, Laozi once more steps up with good advice: “Your own positive future begins in this moment. All you have is right now. Every goal is possible from here.”

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

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