In my last blog post in the finance series, I touched on how the energy and sustainability revolution is transforming the finance industry and impacting corporate strategy, governance and organization. In this post, I’ll focus on the growing awareness of environmental, social and governance (ESG) factors in the investment industry. More than ever, sustainability factors are integrated among key indicators of a company’s overall health, and as such, impact equity valuation and stock performance. Therefore, it is essential for corporate executives to understand how these factors are taken into account by investment professionals.
In Practice: A Growing Awareness of ESG Issues
While sustainable investments may be labeled in a wide variety of ways (e.g., SRI: Sustainable Responsible Impact, socially-responsible investing, responsible investing, sustainable investing, and impact investing), they all share a basic principle: integrating ESG factors into the analysis and decision-making process. In the latest issue of CFA Institute Magazine, Sherree Decovny points out that ESG investing, once a niche market, has “turned into mainstream investing so fast many investors may not have noticed the transformation.” Today, major financial services firms, such as Blackrock, Goldman Sachs, Bain Capital and Morgan Stanley, are proposing ESG investment options among their assets class mix. As with the expansion of the green bonds market (doubling in 2016 vs. 2015), responsible investments have also skyrocketed under the PRI, the world’s leading proponent for ESG-driven investments. As of April 2016, responsible investments represent $62 trillion of assets under management, compared to $6.5 trillion in 2006. Also, thanks to the increasing demand of investors, metrics and research related to ESG performance are developing at fast pace and are widely available through major outlets like Bloomberg, Reuters, MSCI, Sustainalytics and Morningstar.
Duty: Not Only Fiduciary but Also Essential
Today, analysts recognize that in many sectors ESG factors can be vital to a company’s financial health. Ignoring them can be considered as troubling as a breach of the fiduciary duty that analysts and portfolio managers have towards their clients—as detailed in the United Nations Environment Programme – Finance Initiative (UNEP FI)’s recent report, Fiduciary Duty in the 21st Century. ESG factors’ impact on a company’s financial outlooks should be more systematic, complementing the financial analysis of a company’s intrinsic valuation and representing more than a “nice to have” practice. While investment professionals are making significant progress to integrate ESG factors in their investment decision-making process, corporations as a whole will have to increasingly step up and improve their ESG commitments and the quality of their disclosures. As illustrated by the TCFD (Task Force on Climate-related Financial Disclosures), which we’ll discuss in a future blog post, businesses will simply have to get ready to deliver better analysis and quantification of their exposure to material ESG factors.
Returns: No Penalty and Usually a Boost
The question on most professionals’ minds is, as Will Ortel bluntly put it, “Does ESG boost return?” Isn’t it intuitive to believe that a company “doing good” in terms of employee engagement, environmental responsibility, and corporate governance is also “doing well” in terms of financial performance? The short answer is yes. More and more evidence continues to emerge that ESG metrics and financial performance are positively correlated. Morgan Stanley’s report leaves no ambiguity: “Investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments…There is a positive relationship between corporate investment in sustainability and stock price and operational performance.”
However, recent research such as this article by Jeroen Boes, CFA, indicate that ESG scoring does not tell the full story and should be interpreted with caution. A company’s size, activities exposure and peer comparison must all be carefully interpreted—for instance, large companies tend to have higher ESG scores. Quite interestingly, the study also found that investing in companies with positive “ESG momentum” (rising ESG scores), is associated with a better risk-adjusted return. Simply put, investors are looking for companies that are doing both “good” and “well” and who show forward momentum in terms of commitment to sustainability.
Implications for Corporations
Interest in ESG practices continues to grow rapidly among investment professionals, putting increasing pressure on corporates to be more transparent about their corporate sustainability objectives. Because of the impact on a company’s valuation—and subsequent access to capital—ESG key performance indicators should be a C-suite priority and be monitored at the board-level. To reach this level, though, businesses must overcome common challenges like reporting framework harmonization, data collection and standardization, quality control and industry-specific analysis. In the next post in this series, I’ll present various initiatives addressing these specific issues.