Magazine Issues » Dec 2017-Jan 2018

ESG: Under a cloud

Stormy_skyDoubts about esg are on the rise. Catherine Lafferty looks at where the strategy is going wrong and what it might be doing right.

Investment guided by environmental, social and governance (ESG) criteria has never been more popular; across the world, more than a quarter of assets under management are invested using ESG factors. Yet two reports published this autumn cast a shadow over virtuous investing.

A study by Schroders of 500 institutional investors globally found that investing sustainably remains a significant challenge for institutional investors, even though most of them recognise that this approach will grow in importance over the next five years.

Respondents cited performance, transparency and risk concerns as the main hurdles to sustainable investing.

Performance concerns were seen as a barrier by just under half, underlining the suspicions held by many in the asset management community about the profitability of the approach. There were worries too about a lack of transparency, reported data and the difficulty of measuring and managing risk.

The shadow darkened with the release of a report by Hermes that found a steep drop in confidence among institutional investors that ESG produces better long-term returns.

The suspicion that socially responsible investment means foregoing returns has long dogged the ESG approach. At the moment, the evidence is equivocal.

Sean Thompson, of Camradata, says: “With regards to investment return, it is early days. We are seeing too many mixed views that investment returns have improved as a result of taking ESG decisions.”

Nadine Viel Lamare, head of sustainable value creation at Swedish institutional investor AP1, can’t say for sure what lies behind the drop in confidence but points out that the term ESG means different things to different people. She adds: “As there is no single definition of what integrating ESG means, going from pure exclusions to thematic investments, answers from different investors will be influenced by what they have in mind.”

Three methods
According to consultants McKinsey, most institutional investors that integrate ESG factors in their strategies use at least one of three techniques for portfolio construction and management: negative screening, positive screening, and proactive engagement.

At present, negative screening – excluding sectors and companies from investment portfolios based on ESG criteria – is used for two-thirds of sustainable investments. But ESG integration has been growing at 17% a year. This method, which is the systematic and explicit inclusion of ESG factors in financial analysis, is used with nearly half of sustainable investments.

Standards can be patchy, however. McKinsey notes that some investors, including ones of size and sophistication, integrate ESG factors into their processes using techniques that are less rigorous and systematic than those they use for other investment factors.

“When investors bring ESG factors into investment decisions without relying on time-tested standard practices, their results can be compromised,” it warns.

That said, a loss of rigour and decline in investor confidence in ESG is not a picture recognised by AP1.

“We would not say that we do see such a negative trend in Sweden,” says Viel Lamare, adding “There are also some studies showing that integrating ESG aspects in a systematic way decreases drawdowns at portfolio level, i.e should be beneficial to the portfolio performance long term.”

However, she cautions, “We do not believe in ‘best in class’ approaches to ESG, neither do we believe in broad exclusion strategies.”

Not all investors take such a keen interest in ESG. Camradata’s Thompson notes that in general, insurers do not seem to have it on their radar.

“It depends on the investor and who you are talking to, but not all are concerned about having ESG incorporated into their investment processes. Some investors are not so bothered about ESG,” he says.

At the opposite end of the scale are those investors who put a good deal of emphasis on socially responsible investing, such as British institutional investor Brunel Pension Partnership.

Its chief responsible investment officer, Faith Ward, stresses its commitment to responsible investment and stewardship, as well as to being open and transparent: “This will be expanded on in our responsible investment (RI) policy, due to be published in early 2018. It means we integrate ESG factors (as well as political, business strategy, etc) alongside traditional financial factors when making long-term investment decisions.”

Without authorisation from the UK’s Financial Conduct Authority (FCA), expected in April 2018, Brunel cannot hold any assets and will have no information on returns. However, Ward stresses that it does not believe good returns and sustainable investment are an either/or scenario. Increasingly, she says, the evidence is that responsible investment pays off.

“The Environment Agency Pension Fund, which is recognised as leaders in RI, produces some of the best performance and highest funding level across the whole of the Local Government Pension Scheme. The facts speak for themselves,” she adds.

Brunel uses the same risk management approach that it employs with other investment considerations.It admits that communicating how integrating ESG considerations can enhance investment decision-making poses a considerable challenge.

This is not a compromise or a trade-off, says Ward, but simply part of a good decision-making process. She points out that a recent study by the London School of Economics suggested that climate change has major implications for pension funds’ investments and ultimately their ability to provide incomes in retirement for their members.

The Pensions Regulator has also weighed into the debate, saying that it expects pension funds to incorporate ESG considerations, including climate change, into their investment strategies.

Hammered
In Thompson’s view, the opportunity cost of ignoring ESG criteria may be too high. He thinks returns will improve for firms with strong ESG, while those at the other end of the scale may see share values hammered, brand damage, cost increases, management diversions and restrictions on their businesses. “If organisations are not taking this into account, they will be left behind.” When assessing ESG, looking at investment returns alone is insufficient, he adds. Risk-adjusted returns are more useful.

Far from seeing a fall-off in ESG interest, he says there has been an increase in the number of searches for SRI (socially responsible investing) funds. Of the 64 assisted searches in which investors looked for particular mandates this year, 15% were for SRI.

“Demand for funds which take into account SRI factors has more than doubled over the last three years and we expect this rate to increase going forward,” says Thompson.

The scale of the market has wide regional variations, with European asset managers having the largest proportion of sustainable investments, accounting for 52.6% at the beginning of 2016.

If anything, this can be expected to increase. In Schroders’ report, a large proportion (60%) of investors in Europe agreed that investing sustainably will become increasingly important over the next five years. Meanwhile, 20% of investors worldwide said they did not believe in investing sustainably; in Europe, the figure was 15%.

Not everyone is going to be convinced of ESG’s benefits, but its importance is not in doubt. “It is not something that is going away. It is part of a firm’s best practice,” says Thompson.

“Governance has got to be strong. Looking at ESG – no organisation can ignore governance.”

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