Environmental, Social and Governance (ESG) investing has firmly entered the mainstream. Growing awareness, especially of the risks of climate change, is increasing members’ interest in ESG fund options. At the same time, regulatory changes require all pension trustees to set out policies for considering the material financial considerations of ESG issues from October 2019. These include not only climate change but issues such as how schemes exercise voting rights. Schemes will have to publish an implementation statement, including ESG information, annually.
More fundamentally, there is evidence that including ESG considerations in investment decisions leads to better outcomes for members by improving returns and reducing risk. It may also enhance the reputation of trustees. ESG can be used to identify long-term risks and opportunities: climate change, for example, threatens the viability of some assets but could generate returns in others.
Incorporating ESG considerations into investment decisions needs close cooperation between an investment team and ESG specialists. Viewing investment through an ESG lens requires schemes to be active owners, with clear policies on remuneration, effectiveness and disclosure.
“While larger funds may be able to implement an ESG policy using in-house resources, for many small schemes external support will be required.”
ESG data is more diverse than the financial data on which investment decisions have traditionally been based. Some exists in a structured form, such as company reports, although this tends to be backward looking. There are also a number of independent metrics that investors can use to measure company performance, such as the Transition Pathway Initiative, the CDP global disclosure system and Climate Action 100+. Similarly, ESG ratings are available from a number of providers. However, limited corporate transparency and lack of data standardisation mean there is little correlation between different rating agencies and methods of measuring company performance. At the moment, analysis remains as much an art as a science.
Moreover, most data – and certainly most real-time or current information that might reveal improvement trends – is unstructured. This can include information from non-governmental organisations, the media or companies themselves. For example, the reporting of emissions data may be subject to different standards and different criteria. For investors to use data effectively to assess risks, this information needs to be structured. Investors with significant resources may be able to do this in-house but external support will be necessary for most.
Within the field of socially responsible investing (SRI), there is an active debate about the relative importance of ESG and impact investing. ESG criteria largely focus on company practices, such as raw material sourcing or manufacturing processes. In contrast, impact considers the effect that company’s goods or services have on the world. ESG and impact can overlap but may also be mutually exclusive. For example, many tobacco companies operate in accordance with ESG guidelines but their products have a negative impact on people’s health.
One way of considering the impact of potential investments is to assess them against the United Nations Sustainability Development Goals (SDGs), which were established in 2015 with a target date of 2030. The 17 SDGs and the dozens of sub-SDGs are often inexact and sometimes overlapping. Nevertheless, they are a useful way to quantify and compare ‘performance’ and, so far, the closest thing to a standardised way of measuring sustainability available to the industry. Impact draws on the collective and independent view of a company’s products and services on the sustainability of people, planet and pocket, which is often aligned to the SDGs.
Since ESG investing first came to prominence, opinion has divided over whether investors should divest assets that fail to meet ESG thresholds or engage with those companies to encourage them to change their strategies. Increasingly, most investors support an engagement approach.
“Engagement has the potential to create greater economic and ESG value in the long term, benefiting both society and investors.”
Taking an ownership stake enables an investor to exert influence through their voting rights – possibly by collaborating with other investors. It also provides an opportunity to better understand the consequences of company practices and encourage improved ESG reporting.
While ESG and SRI tend to resonate more strongly with millennials – and may prompt some to begin saving for their retirement – ESG assessment is expected to become mainstream investment best practice in the coming years. It will add rigour to investors’ regular analytical exercises when identifying new investments and evaluating existing ones.
Investors are likely to place different emphasis on the different elements of environmental, social and governance depending on their investment strategies. It should be noted that better governed companies tend to address environmental and social issues more effectively. However, there is no guarantee that companies with a commitment to environmentalism will have sound governance practices. Nevertheless, environmental and social issues are becoming more important to many corporations. This is both due to higher regulatory standards and because some of these issues are becoming financially material. For instance, failure to address supply chain management problems can create potential financial liabilities.
BNY Mellon assumes no liability for the content, including statistics, herein. All content, including statistics, was derived from discussions and presentations that took place at the BNY Mellon Pension Summit in London on 14 November 2018.
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