The Rise of ESG
Several large banks and fund houses are realising that their definition of what is financially relevant needs to involve environmental, social and governance (ESG) factors. These issues are now becoming critical in investment decision-making. Investors are incorporating these to reduce risk and seize opportunities by fine-tuning equity exposures, searching for excess returns, remaking bond portfolios and tapping the green bond market. ESG represents about one-quarter of all professionally managed assets around the world. According to the 2018 Edelman Trust Barometer Special Report: Institutional Investors, 66 per cent of U.S. investors said that their firm altered its voting or engagement policy to be more attentive to ESG risks in the last year alone. These include:
Environment: Focuses on a company’s environmental disclosure, environmental impact, and, any efforts to reduce pollution or carbon emissions
Social: Refers to the workplace mentality (diversity, management, human rights) as well as any relationship surrounding the community (philanthropy or corporate citizenship)
Governance: Accounts for compensation, shareholder rights, and the relationship between shareholders and management
The practice of ESG investing began in the 1960s as socially responsible investing (SRI), with investors initially excluding stocks or entire industries from their portfolios based on their involvement in business activities, such as tobacco production or their implicit support of the South African apartheid regime.
While ethical considerations and alignment with values remain common motivations of many of today’s ESG investors, the field is rapidly growing and evolving. For asset owners who seek to invest in a way that is aware of and responsive to climate change, solutions in the marketplace have traditionally focused on mitigation: reducing the effects of climate change on a portfolio by, for example, reducing exposure to greenhouse gases and increasing exposure to ‘green’ energy companies. As extreme weather events become more frequent and the economic impacts of climate change more widely understood and accepted, investors will require companies to disclose how they are adapting their business strategies to accommodate the impacts of climate change.
Many investors now look to incorporate ESG factors into the investment process alongside traditional financial analysis. As part of this process, investment firms gather ESG data on companies and use this to make decisions on valuation and risk that a stock poses. With investors looking at ESG as a value-based dimension of their portfolio, they increasingly want to understand ESG performance the same way they would any other traditional financial measure. This, is leading to greater interest in robust ESG reporting along dimensions such as carbon intensity, controversy exposure, and overall ESG profile.
Once considered a niche market for institutional clients with specialised investment needs, ESG investing has gone mainstream. It now spans multiple asset classes and is used by a diverse group of investors. We have tracked ESG over the six years of our study and it indicates that companies are putting significant efforts to improve their performance.