The Remarkable Rise Of ESG
LINFEN, June 26, 2018 -- Photo taken on June 26, 2018 shows the Hukou Waterfall on the Yellow River, which is located on the border area between north China's Shanxi and northwest China's Shaanxi provinces. (Xinhua/Lyu Guiming) (Xinhua/Lyu Guiming via Getty Images)
Responsible investing is widely understood as the integration of environmental, social and governance (ESG) factors into investment processes and decision-making. ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis, yet may have financial relevance. This might include how corporations respond to climate change, how good they are with water management, how effective their health and safety policies are in the protection against accidents, how they manage their supply chains, how they treat their workers and whether they have a corporate culture that builds trust and fosters innovation.
The term ESG was first coined in 2005 in a landmark study entitled “Who Cares Wins.” Today, ESG investing is estimated at over $20 trillion in AUM or around a quarter of all professionally managed assets around the world, and its rapid growth builds on the Socially Responsible Investment (SRI) movement that has been around much longer. But unlike SRI, which is based on ethical and moral criteria and uses mostly negative screens, such as not investing in alcohol, tobacco or firearms, ESG investing is based on the assumption that ESG factors have financial relevance. In 2018, thousands of professionals from around the world hold the job title “ESG Analyst” and ESG investing is the subject of news articles in the financial pages of the world’s leading newspapers. Many investors recognize that ESG information about corporations is vital to understand corporate purpose, strategy and management quality of companies. It is now, quite literally, big business. But what explains the remarkable rise of ESG investing and what does this mean for the future?
The story of ESG investing began in January 2004 when former UN Secretary General Kofi Annan wrote to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative under the auspices of the UN Global Compact and with the support of the International Finance Corporation (IFC) and the Swiss Government. The goal of the initiative was to find ways to integrate ESG into capital markets. A year later this initiative produced a report entitled “Who Cares Wins,” with Ivo Knoepfel as the author. The report made the case that embedding environmental, social and governance factors in capital markets makes good business sense and leads to more sustainable markets and better outcomes for societies. At the same time UNEP/Fi produced the so-called “Freshfield Report” which showed that ESG issues are relevant for financial valuation. These two reports formed the backbone for the launch of the Principles for Responsible Investment (PRI) at the New York Stock Exchange in 2006 and the launch of the Sustainable Stock Exchange Initiative (SSEI) the following year.
Today, the UN-backed PRI is a thriving global initiative with over 1,600 members representing over $70 trillion assets under management. PRI’s role is to advance the integration of ESG into analysis and decision-making through thought leadership and the creation of tools, guidance and engagement. The SSEI, supported by the Geneva-based UNCTAD, has grown over the years with many exchanges now mandating ESG disclosure for listed companies or providing guidance on how to report on ESG issues. However, despite its rapid growth into the mainstream, the rise of ESG investing has been neither smooth nor linear.
Institutional investors were initially reluctant to embrace the concept, arguing that their fiduciary duty was limited to the maximization of shareholder values irrespective of environmental or social impacts, or broader governance issues such as corruption. Incredibly, such arguments are still being made. But as evidence has grown that ESG issues have financial implications, the tide has shifted. In many important markets, including the U.S. and the EU, ESG integration is increasingly seen as part of fiduciary duty. See, for example, Al Gore's update on relevant developments.
Another major barrier has been a lack of data and the necessary tools to get a handle on the fragmented and incomplete information available. However, corporate disclosure on ESG issues has steadily improved since the launch of the Global Reporting Initiative (GRI) in 2000. Today, 80% of the world’s largest corporations use GRI standards. More recently, the International Integrated Reporting Initiative (IIRC) and the US-based Sustainability Accounting Standard Board (SASB) have helped to advance industry sector-specific reporting and its relevance for investors. Overall, the market for ESG information is maturing and quality, while still imperfect, is getting better all the time. And new technology based on machine learning and big data can already unlock valuable insights and offer easy ways to apply ESG data in addition to conventional financial information.
The steady growth of ESG investing was greatly accelerated around 2013 and 2014 when the first studies were published showing that good corporate sustainability performance is associated with good financial results. Work by academics such as George Serafeim, Bob Eccles and Ioannis Ioannou shows the importance of ESG information for assessing corporate risks, strategies and operational performance.
Stocks of sustainable companies tend to significantly outperform their less sustainable counterparts
The idea that investors who integrate corporate environmental, social and governance risks can improve returns is now rapidly spreading across capital markets on all continents. In Europe, for example, a critical mass of pension funds and insurers have started to award new business exclusively to asset managers with ESG capabilities. The global investor community has developed a variety of methods for optimally integrating ESG information, such as outlined in A Practical Guide To ESG Integration for Equity Investing). Among the many ESG factors that are viewed as having financial relevance are especially those related to climate change. The reason for this is that climate change is no longer a distant threat on the horizon, but one that is here and now, with multi-billion-dollar economic consequences. Many investor initiatives are now pushing for de-carbonization and the Task Force on Climate-related Financial Disclosures (TCFD) has given much impetus for improving risk preparedness and, by implication, de-carbonization actions.
Cynics may argue that responsible investing is just a fad. But a closer look at the forces that have driven the movement over the past 15 years suggests otherwise. Firstly, technology and the rise of transparency are here to stay. Gathering and processing data will become ever easier and cheaper. Smart algorithms will increasingly allow for better interpretation of non-traditional financial information which seems to be doubling in volume every couple of years. Secondly, environmental changes, in particular climate change, will with scientific certainty put a growing premium on good stewardship and low carbon practices as natural assets will appreciate in value over time. And thirdly, people everywhere are increasingly empowered by technology. ESG investing allows them to express their own values and to ensure that their savings and investments reflect their preferences, without compromising on returns.
The rise of ESG investing can also be understood as a proxy for how markets and societies are changing and how concepts of valuation are adapting to these changes. The big challenge for most corporations is to adapt to a new environment that favors smarter, cleaner and healthier products and services, and to leave behind the dogmas of the industrial era when pollution was free, labor was just a cost factor and scale and scope was the dominant strategy. For investors, ESG data is increasingly important to identify those companies that are well positioned for the future and to avoid those which are likely to underperform or fail. For individuals, ESG investing offers the opportunity to vote with their money. And for policy makers, it should be a welcome market-led development that ensures that the common good does not get lost in short-term profit making at any cost.
Today, ESG investing has matured to the point where it can greatly accelerate market transformation for the better. As corporations and investors experience growing influence and power, their actions and decisions increasingly shape the future. Provided that political framework conditions based on openness and global rules do not deteriorate further, market-led changes will act as a force for good on a truly massive scale.