Recent studies show ESG implementation in mainstream finance has improved significantly, presenting opportunities for sustainable, long-term returns.
In recent years, Environmental, Social and Governance (ESG) implementation has transformed from a niche to mainstream activity, as asset managers, asset owners, and pension funds increasingly recognize the importance of ESG factors to investors, stakeholders, and shareholders. Issues such as climate change, remuneration, modern slavery, and equal pay have led to the integration of ESG into investment processes.
Incorporating ESG Factors and Metrics
The Principles of Responsible Investment (PRI) describe “responsible investing” as an approach to integrating ESG factors, which are not traditionally part of financial analysis, into investment and decision-making processes to better manage risk and generate sustainable, long-term returns.
ESG factors and metrics are numerous but external to the traditional canon of financial metrics. ESG factors include:
- Climate change
- Resource depletion
- Waste and pollution
- Working conditions
- Local communities
- Health and safety
- Employee relations
- Executive pay
- Bribery and corruption
- Political contributions and lobbying
- Board diversity and structure
ESG metrics can be used to evaluate a company’s performance with regard to ESG risks. Environmental metrics may examine how a company manages ownership of contaminated land, disposal of hazardous waste, or reduction of toxic emissions. Social metrics may examine a company’s business relationships (e.g., if the company works with suppliers that hold similar values) and working conditions (e.g., if the company shows a high regard for workers’ health and safety). Governance metrics may examine how the company is run (e.g., if the company uses accurate and transparent accounting methods, eschews illegal practices, and avoids conflicts of interest in board member selection).
Monitoring the Trends That Are Shaping ESG
Several major events and trends have influenced ESG’s shift toward the mainstream in recent years. First, the 2008 financial crisis underlined how important good governance practices are, and how culture and conduct have a major effect on company success and market perception. Climate change has driven a move toward sustainable investment largely due to the fact that it has become a present challenge, rather than a distant threat.
Second, ESG reporting is increasing, with a recent LP Footprint Project report finding that 63% of limited partners have ESG policies, 59% have self-selected to be signatories with the PRI, and 40% publicly publish annual ESG reports.[i]
Third, market participants have begun to recognize the value in ESG reporting. ESG metrics help manage risk by enabling a deeper assessment and understanding of risk, and close monitoring during the investment period. ESG reporting can indicate strong corporate oversight and clear, transparent engagement with investors, which can drive value and confidence in the organization.
Analysing the Studies Showing Increased ESG Implementation
In April 2019, BNP Paribas Securities Services published The ESG Global Survey 2019 examining 350 asset owners and managers and their attitudes toward ESG issues and strategies. The survey found that ESG factors are increasingly embedded in asset owner and manager activities due to the benefits of effective ESG performance, such as increased returns and better risk management. BNP found that 75% of asset owners and 62% of asset managers held greater than 25% of their funds in ESG-related funds — a significant increase from 48% of asset owners and 53% of asset managers in 2017.
Asset owners and managers also see responsible investing as a method of positively contributing to the UN Sustainable Development Goals (SDGs) and related key performance indicators that are being built into investment frameworks, and 65% of respondents stated that their investment framework is aligned with the SDGs. Motivations for ESG investing included improved long-term returns (52% of respondents), positive impact on brand and reputation (47%), and decreased investment risk (37%).
Standard & Poor’s
In April 2019, Standard & Poor’s released a report titled Exploring Links to Corporate Financial Performance. The report notes that companies focusing on ESG issues have reduced costs, improved worker productivity, mitigated risk potential, and created revenue-generating opportunities. In turn, the report shows, ESG-related investments have benefitted greatly from high-profile market participants pushing ESG into the spotlight and the momentum generated by the PRI.
The report notes that assets invested according to ESG strategies reached US$30 trillion in 2018, following a 25% increase to US$24 trillion between 2014 and 2016. ESG factors and metrics can provide valuable insight into possible current and future ESG risks that may have the potential to directly or indirectly impact profits and returns. The early-warning nature of ESG factors can also contribute to long-term financial performance.
The report considers that while ESG implementation is strong, further academic research is required to confirm definitive empirical links between ESG factors, mitigation, and financial performance.
Understanding the Challenges to Greater ESG Implementation
To embed ESG further into investment processes, procedures, and activities, many challenges need to be met. According to the BNP Paribas report, respondents considered data to be the top barrier to ESG integration. Inconsistent data, conflicting ESG ratings or indices, data gaps, and inconsistent coverage across asset classes all contribute to poor scenario analysis. Better quality and more consistent data is required to ensure that effective scenario analysis can be conducted.
The next barrier was costs. Respondents appreciated the need to spend on technology in order to better aggregate data, produce ESG reports, benchmark performance, produce profiles, and create new sustainability-based products. Investing in smart technologies has the potential to take ESG to the next level and allow investors to assess the performance and sustainability of investee companies with improved accuracy.
Respondents overwhelmingly found the “Social” factor of ESG to be the most challenging to analyze and subsequently incorporate into investment analysis. Investors continue to grapple with the complexity of Social factors, and the lack of a definite, industry-wide definition of what Social factors are, and what they encompass, creates confusion.
ESG has clearly crossed over to the mainstream, with increasing adoption by asset owners, asset managers, and pension funds, but there is more to come. Greater ESG integration depends on market participants finding solutions to the challenges outlined above, which will bring a broader and deeper understanding of data trends, and allow better analysis of risk going forward.
Latham & Watkins will continue to monitor developments in this area.
The authors would like to thank Martin Cassidy for his contribution to this blog post.