Environmental, Social and Governance(ESG): The latest investment on the block

In 1999 Kofi Annan-the then secretary general of the United Nations- was in Davos, Switzerland and he proposed the idea of “Global Compact”, which was supposed to put a human face to the ever growing global financial markets. Following this, in 2005 a group of the world’s largest institutional investors were invited to create the Principles of Responsible Investment (PRI). These principles are the following:

• Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
• Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
• Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
• Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
• Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
• Principle 6: We will each report on our activities and progress towards implementing the Principles.

The principles were then launched on the NYSE in 2006. As of now there are close to 3,000 signatories, representing both financial and non- financial corporations..

These served as the foundations of Environmental, Social and Governance (ESG), which has expanded in recent years.

What exactly is Environmental, Social and Governance(ESG)?

From the above PRI Environmental, Social and Governance (ESG) investments were born, so as to bring a measured approach as well as align long-term investments with them. The idea behind the ESG principles is to measure the impact companies have on their operating environment and the stakeholders they interact with, while raising awareness and bringing accountability for the actions which corporations take.

Although, as everything else in the real world, the effects of any decision a company makes could take many shapes and forms across countless domains. Although the idea of companies taking responsibility for their actions sounds very appealing and even revolutionary in a capitalist society, it gets a little more complex. Today all ESG reporting and disclosures are purely on a voluntary basis and there is no widely accepted standard or a governing body to oversee or enforce it.

In the last few years there been a number of attempts by different market players to come up with a system to evaluate the ESG impact and disclosures of companies. One such attempt was done by the rating agencies Some of the measures that could be used for ESG are the following:

Environmental: Climate Change, Pollution & Waste, New clean technology, limit over- of natural resources, carbon emissions

Social: Responsible supply chains, developing employees, privacy and data security, product safety, responsible investments

Governance: board diversity, equal pay, ethical behavior, anti-corruption, anti-competitive behavior

However, as of now there is no clear consensus on which metrics should be looked at overall even for the same companies and that brings a lot of confusion from an investor perspective. The divergence between different rating agencies stems from three main areas:

What should be considered in scope to measure ESG?

Which measures should have a higher or lower weight in the calculation?

If different metrics are used to measure for the same companies that can obviously bring serious misalignment in ratings.

MIT Sloan have published a very interesting analysis on this topic(https://mitsloan.mit.edu/ideas-made-to-matter/why-esg-ratings-vary-so-widely-and-what-you-can-do-about-it ), which I would recommend for anyone to go over.

An alternative suggestion to measure some of these impacts is using ISO certificates. ISO certificates are bestowed on companies that meet certain requirements. One such certificate is the ISO 50001, which deals with Energy Management Systems. In order for a company to obtain it they have to develop an efficient energy policy; create targets and objectives; measure results; review their energy policy constantly; continuously improve their energy management. Two very prominent organizations have receives the ISO 50001- Hilton and An Garda Síochána-Ireland’s national police force. Hilton has been able to reduce its’ energy intensity by 20.6% and reduce its’ carbon emissions by 30% from a 2008 baseline thanks to implementing and following ISO 50001.

Does ESG have any financial impact on investment performance?

It depends on who you ask. There have been several studies since ESG emerge on the scene and the conclusions are not so clear cut.

In 2017, Allianz conducted an overview of ESG investments and summarized a lot of studies and discussed their results in great detail. What they found based on the academic literature is that ESG has some effect, specifically on companies with high ESG, where their bonds would tend to perform better and have lower credit spreads. So currently, high ESG could translate to better credit performance and strength. The effect seemed to be more pronounced for Investment Grade (IG) investments. However, the performance in question is dependent on the time period examined and might be difficult to replicate.

Another interesting aspect is that there is increased interest in ESG investments. Currently, there are $21 trillion investments under ESG strategy according to Principles for Responsible Investment (PRI). The Alternative Investment Management Association (AIMA), which carries a lot of research in this area found that out of 582 institutional investors found that close to 21% of them practice full integration of ESG factors and 47% use exclusionary strategies. Performance-wise 25% of the investors thought that ESG would perform in less than a year but given a 3-year time frame 75% thought that ESG would underperform.

Issues with ESG

Firstly, ESG is a relatively new concept that has been taking strides into the financial world there is no clear consensus on how to measure these factors. The big rating agencies-Moody, S&P, Fitch and other research organizations each use different methodologies, factors, and ratings which create a lot of confusion amongst investors. It is not unusual to find different ESG ratings for the same companies that vary wildly given the different metrics used to arrive at the valuation.

Secondly, ESG investments currently tend to be skewed towards the technology sector, which is one of the sectors that have experienced rapid growth over the last decade. The famously dubbed FAANG-Facebook, Apple, Amazon, Netflix and Google are currently worth close to $5 trillion dollars. And if we put Microsoft-another technology giant, the value exceeds $6.5 trillion. As an example just Apple, worth close to $2.3 trillion, is worth more than the FTSE 100- the UK’s 100 largest companies. The reasons are that technology companies mainly produce digital products, which are accessed by the internet and they don’t create as much pollution as other industries. Some have pointed out that this could be one of the reasons for the outperformance of ESG, given its’ high skewness towards the tech sector.

Thirdly, ESG is becoming popular because of the principles behind it rather than full-proof of its’ results, which is another criticism. Artificially, placing restrictions on investments might limit the exposure to other companies that could outperform the market, when not bound by ESG considerations are being ignored for trivial reasons, which are very difficult to measure as of yet.

In conclusion

ESG has become a buzzword of recent years that has had a tremendous impact on the financial world. Given its’ high prominence and exposure it has definitely left its’ mark. Whether ESG would continue in its’ trajectory remains to be seen given that it is still in the early stages of how it should be measured and which factors/metrics should be focused more on to make these financial decisions. One thing is certain and the pursuit for returns above the market rate will continue and if ESG is part of that puzzle it would definitely be worth watching out for it.

Sources Used(not an exhaustive list):

BlackRock launches Europe’s first multi-asset ESG ETF range

ESG Ratings – MSCI

MSCI ESG Indexes – MSCI

ESG Foundations – MSCI

MSCI ESG ratings now publicly available

ISO – ISO 50001 — Energy management

Is ESG Just a Fad? | Morningstar

Does ESG investing make financial sense? | The Evidence-Based Investor

ESG investing: Numbers suggest green investing 'mega trend' is here

US business schools realise ESG is no fad but part of long-term trend | Financial Times

ESG Investing Shines in Market Turmoil, With Help From Big Tech – WSJ

ESG: More Than an Investment Fad | Bain & Company

ESG Integration on the Rise: And how to implement it in your portfolio

The MSCI Principles of Sustainable Investing – MSCI-ESG-House-View-FINAL.pdf

Five myths of socially responsible investing (SRI)

Five myths about ESG investing – Embark Group

ESG framework | McKinsey

Evolution of ESG – Citywire

The Remarkable Rise Of ESG

History of ESG Investments. The roots of ESG(Environment, Social… | by Abhilasha Purwar | Blue Sky Thinking | Medium

PRI | Home

MSCI ESG Ratings brochure – MSCI-ESG-Ratings-Brochure-cbr-en.pdf

Foundations of ESG Investing – Part 1: How ESG Affects Equity Valuation, Risk and Performance – MSCI

MSCI KLD 400 Social Index – 904492e6-527e-4d64-9904-c710bf1533c6

MSCI ESG Indexes Factsheet – MSCI-ESG-Indexes-Factsheet.pdf

ISO 50001 – Energy Management system – PUB100400.pdf

Green Bond Definition

What Are Green Bonds and How `Green' Is Green?: QuickTake – Bloomberg

The Green Bond Market in the Nordics | Climate Bonds Initiative

Nordic issuers release 2020 update to their green bonds impact reporting guide – MuniFin

cbi-nordics-final-03b.pdf

Has ESG affected stock performance? – MSCI

C40

C40 Cities Climate Leadership Group – Wikipedia

Moody's ESG & Climate Risk

Morningstar

ESG funds see record inflows in 2019

MSCI ESG Fund Ratings Exec Summary Apr2020 – MSCI+ESG+Fund+Ratings+Exec+Summary+Methodology.pdf

Factor Investing – MSCI

MSCI factor indexes – MSCI

ESG White Paper FINAL.pdf

Corporate Bonds Through a Factor and ESG Lens – MSCI

ESG in Credit Ratings | S&P Global Ratings

esg-in-ig-bonds.pdf

Why ESG integration works for bonds – Newton

In Memory Of Kofi Annan: Father Of The Modern Corporate Sustainability Movement

About the PRI | Other | PRI

What are FAANG stocks? | Wealthify.com

Apple more valuable than the entire FTSE 100 – BBC News

https://mitsloan.mit.edu/ideas-made-to-matter/why-esg-ratings-vary-so-widely-and-what-you-can-do-about-it

https://d8g8t13e9vf2o.cloudfront.net/Uploads/g/f/c/priannualreport_605237.pdf