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ESG – Latest Developments in A Rapidly Growing Investment Theme
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- Climate change and ESG investing is one of the recurring investment themes of 2021
- We recap the basics of ESG, and look through some common metrics and strategies employed by companies and fund houses today
- With the popularity of ESG, greenwashing has grown to be a pervasive and insidious issue, and we share some tips on how investors can navigate through this issue
As with many megatrends, ESG as a concept has existed for longer than most investors would expect. ESG investing began in January 2004, when Kofi Annan, then the Secretary General of the UN, invited major financial institutions to participate in a joint initiative to integrate ESG into capital markets. This eventually resulted in a report titled “Who Cares Wins” by Ivo Knoepfel, and thus the ESG movement was born.
The ESG movement was initially held back by two key reasons: (i) it was not seen as important at that time, and (ii) the lack of data and tools to collect and analyse the relevant data. This changed about 7 to 8 years ago when studies started to emerge showing that good ESG performance is associated with good financial results. The improvement of technology has also allowed for better data collection and analysis, allowing companies and investors to take the necessary actions in the hope of unlocking better financial performance.
Since then, there has been a remarkable paradigm shift towards ESG investing. While previously thought of as a supplementary consideration, it is now widely used as a key part of fundamental analysis. With climate change a menacing, pressing issue, ESG investment will continue to remain in the spotlight, and we would like to familiarise investors with some common metrics and strategies that are prevalent in the industry.
A ESG Primer – The basics, the metrics & the strategies
The Basics
ESG investing, or sustainable investing, is an investment approach that considers environmental, social and governance factors alongside traditional considerations in financial factors when it comes to investment decisions. A breakdown of the factors are as follows:
When the topic of ESG gets brought up, the environmental criteria is typically the one at the forefront of most investors’ minds. However, investors should not neglect the other criteria, as they are arguably more important. While the environment factor gets more views and clicks, the other two factors are typically signs of a good, well-managed company, which are the companies that investors should look to invest in anyway.
The Metrics
ESG metrics are largely provided by third party agencies (much like bond ratings) that generally utilize their own methodology to collect and analyse data related to a diverse array of ESG issues. They can be roughly divided into the following groups, although there are companies that fulfil multiple roles:
Figure 1: Sustainable development goals established by the United Nations
While ESG reporting standards has come a long way, many challenges remain. Issues relating to finding consensus with ESG metrics and a standardised reporting system remain in limbo.
The complexity of the global geopolitical environment and the differences in operating practices across industries makes a standardized ESG benchmark challenging to establish, and ratings provided by the many ESG rating agencies tend to show low correlation due to the different methodologies used. Even from the perspective of fund houses, many of them use their own proprietary ESG ratings and measurements. For the truly ESG conscious investor, it is recommended to reconcile these differences by conducting their own due diligence.
The Strategies
ESG strategies fall broadly into the following categories, with different levels of ESG incorporation:
Some examples of funds that adhere to specific ESG strategies are as follows:
Exclusionary ESG screening is generally the standard market practice today. Investors who seek to make a bigger difference in advancing these positive initiatives should look more towards positive selection or impact investing, and can consider some of the examples proposed in the table above. However, it is also worth noting that the strategies presented are closer to guidelines along a scale rather than clear defined categories, and there are likely to be overlaps between strategies.
There has also been an increase in the number of fixed income ESG funds available on the market, although these strategies rely mostly on exclusionary screening or positive selection of issuers to meet the ESG criteria. However, good ESG performance is an important consideration for fixed income investors as well, as poor ESG compliance often leads to regulatory or reputational risk, which could affect the company’s credit and its ability to finance its debt obligations.
The two exceptions here are the Eastspring Asia Sustainable Bond Fund and the Manulife Sustainable Asia Bond Fund, as they have significant allocation of around 20% into Green bonds, which are bonds issued to support climate and environmental projects.
While the increased focus on ESG is good for the space (and the world) as a whole, it has led to the rise of another new challenge – greenwashing.
Greenwashing
Greenwashing is the process of conveying a false impression or providing misleading information about how environmentally friendly a product is. With the attention ESG investing has garnered in recent times, greenwashing works as an effective marketing tool to attract ESG conscious investors. Combating greenwashing requires a two-pronged approach, from both top-down regulations from governments and bottom-up investor due diligence.
Currently, regulators worldwide are making their move with emphasis on improving regulations in the ESG space. In the US, the SEC is considering updating its naming rule for funds to combat greenwashing, and in Asia, the ASIFMA (Asia Securities Industry & Financial Markets Association) is also implementing new requirements and attempting to establish a common standard across the board. In the meantime, investors have to rely on their own due diligence. While not exhaustive, here are some tips investors can use to avoid greenwashing:
One good consideration is a fund house’s commitment to ESG investing. Do they have their own proprietary ESG evaluation scale or do they simply rely on third parties? Having their own methodology suggests commitment to the ESG cause, and these companies are more likely to not just include ESG considerations in their asset management, but in the day-to-day running of their company as well. For example, Fidelity relies on their own proprietary ratings to analyse their companies.
Figure 2: Fidelity’s methodology for ESG analysis
The ESG movement was initially held back by two key reasons: (i) it was not seen as important at that time, and (ii) the lack of data and tools to collect and analyse the relevant data. This changed about 7 to 8 years ago when studies started to emerge showing that good ESG performance is associated with good financial results. The improvement of technology has also allowed for better data collection and analysis, allowing companies and investors to take the necessary actions in the hope of unlocking better financial performance.
Since then, there has been a remarkable paradigm shift towards ESG investing. While previously thought of as a supplementary consideration, it is now widely used as a key part of fundamental analysis. With climate change a menacing, pressing issue, ESG investment will continue to remain in the spotlight, and we would like to familiarise investors with some common metrics and strategies that are prevalent in the industry.
A ESG Primer – The basics, the metrics & the strategies
The Basics
ESG investing, or sustainable investing, is an investment approach that considers environmental, social and governance factors alongside traditional considerations in financial factors when it comes to investment decisions. A breakdown of the factors are as follows:
When the topic of ESG gets brought up, the environmental criteria is typically the one at the forefront of most investors’ minds. However, investors should not neglect the other criteria, as they are arguably more important. While the environment factor gets more views and clicks, the other two factors are typically signs of a good, well-managed company, which are the companies that investors should look to invest in anyway.
The Metrics
ESG metrics are largely provided by third party agencies (much like bond ratings) that generally utilize their own methodology to collect and analyse data related to a diverse array of ESG issues. They can be roughly divided into the following groups, although there are companies that fulfil multiple roles:
- Standard setters: These organisations generally provide standards for companies to meet, as well as structure and provide guidelines for ESG reporting. Examples of such organisations include the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI). Another common standard practiced are basing guidelines off the United Nations Sustainable Development Goals (Fig. 1).
- Data providers and aggregators: These organisations collect and provide data related to particular ESG issues. Many of these organisations double up as rating agencies, and they have their own methodology in evaluating how well a company complies with ESG standards. These include general data aggregators like Bloomberg and Thomson Reuters, as well as more specialized companies like Sustainalytics, which were acquired by Morningstar in 2020.
Figure 1: Sustainable development goals established by the United Nations
Source: United Nations
While ESG reporting standards has come a long way, many challenges remain. Issues relating to finding consensus with ESG metrics and a standardised reporting system remain in limbo.
The complexity of the global geopolitical environment and the differences in operating practices across industries makes a standardized ESG benchmark challenging to establish, and ratings provided by the many ESG rating agencies tend to show low correlation due to the different methodologies used. Even from the perspective of fund houses, many of them use their own proprietary ESG ratings and measurements. For the truly ESG conscious investor, it is recommended to reconcile these differences by conducting their own due diligence.
The Strategies
ESG strategies fall broadly into the following categories, with different levels of ESG incorporation:
Some examples of funds that adhere to specific ESG strategies are as follows:
^The above table is not an exhaustive list of the ESG funds available on the platform
Exclusionary ESG screening is generally the standard market practice today. Investors who seek to make a bigger difference in advancing these positive initiatives should look more towards positive selection or impact investing, and can consider some of the examples proposed in the table above. However, it is also worth noting that the strategies presented are closer to guidelines along a scale rather than clear defined categories, and there are likely to be overlaps between strategies.
There has also been an increase in the number of fixed income ESG funds available on the market, although these strategies rely mostly on exclusionary screening or positive selection of issuers to meet the ESG criteria. However, good ESG performance is an important consideration for fixed income investors as well, as poor ESG compliance often leads to regulatory or reputational risk, which could affect the company’s credit and its ability to finance its debt obligations.
The two exceptions here are the Eastspring Asia Sustainable Bond Fund and the Manulife Sustainable Asia Bond Fund, as they have significant allocation of around 20% into Green bonds, which are bonds issued to support climate and environmental projects.
While the increased focus on ESG is good for the space (and the world) as a whole, it has led to the rise of another new challenge – greenwashing.
Greenwashing
Greenwashing is the process of conveying a false impression or providing misleading information about how environmentally friendly a product is. With the attention ESG investing has garnered in recent times, greenwashing works as an effective marketing tool to attract ESG conscious investors. Combating greenwashing requires a two-pronged approach, from both top-down regulations from governments and bottom-up investor due diligence.
Currently, regulators worldwide are making their move with emphasis on improving regulations in the ESG space. In the US, the SEC is considering updating its naming rule for funds to combat greenwashing, and in Asia, the ASIFMA (Asia Securities Industry & Financial Markets Association) is also implementing new requirements and attempting to establish a common standard across the board. In the meantime, investors have to rely on their own due diligence. While not exhaustive, here are some tips investors can use to avoid greenwashing:
One good consideration is a fund house’s commitment to ESG investing. Do they have their own proprietary ESG evaluation scale or do they simply rely on third parties? Having their own methodology suggests commitment to the ESG cause, and these companies are more likely to not just include ESG considerations in their asset management, but in the day-to-day running of their company as well. For example, Fidelity relies on their own proprietary ratings to analyse their companies.
Figure 2: Fidelity’s methodology for ESG analysis
Another key consideration is whether the fund house can quantify the impact that their investment choices has made. For example, the Mirova Global Sustainable Equity Fund provides their key impact indicators, and it signifies their commitment to make their ESG efforts measurable. These numbers can typically be found in a fund house’s ESG reports, which is a good indicator of a fund house’s commitment.
Figure 3: Mirova ESG Report quantifying the carbon impact of their asset allocation
Source: Mirova Impact Report 2019
Finally, investors can look to external ratings to get a good gauge on how closely a fund follows its ESG mandate. Labels and awards are often listed in a fund factsheet, and these awards could be issued by external agencies, such as MSCI, Bloomberg, or Morningstar with its newly acquired Sustainalytics wing. These labels could also be issued by governments or environmental agencies, and are good signs that a fund follows through well with its ESG mandate.
Figure 4: MSCI ESG Fund Rating for Blackrock Sustainable Energy Fund
Source: BGF Sustainable Energy Fund Factsheet (Feb 2021)
Figure 5: ISR Rating issued by the French Ministry of Economy and Finance
Source: Natixis-Mirova Global Sustainable Equity Fund Factsheet (Feb 2021)
Closing Thoughts
With significant fund flows and a renewed interest in climate change, ESG investing is certainly one of the hottest investment trends in 2021. Whether you believe ESG investing is here to stay or simply just a passing fad, we believe that is important for investors to stay aware of developments in the investment world. As part of our ongoing series, do keep an eye out for our next article, where we will look at the perennial question: “Do ESG funds outperform?”
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Disclaimer
The information provided in this report is of a general nature and has been prepared for information purposes only. It is not intended to constitute research or as advice for any investor. The information in this report is not and should not be construed or considered as an offer, recommendation or solicitation for investments. Investors are advised to make their own independent evaluation of the information contained in this report, consider their own individual investment objectives, financial situation and particular needs and should seek appropriate personalised financial advice from a qualified professional to suit individual circumstances and risk profile.
The information contained in this report is prepared from data believed to be correct and reliable at the time of issuance of this report. While every effort is made to ensure the information is up-to-date and correct, Bond and Sukuk Information Platform Sdn Bhd (“the Company”) does not make any guarantee, representation or warranty, express or implied, as to the adequacy, accuracy, completeness, reliability or fairness of any such information contained in this report and accordingly, neither the Company nor any of its affiliates nor its related persons shall not be liable in any manner whatsoever for any consequences (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) of any reliance thereon or usage thereof.
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