Environmental, social and governance (ESG) issues is a hot topic, particularly against the background of the agreement of the UN’s Sustainable Development Goals and the Paris Agreement on Climate Change in 2015. As these issues move into the foreground, Therese Niklasson, Global Head of ESG, and Naasir Roomanay, ESG Analyst, consider both the investment opportunities that may arise from viewing the world through an ESG lens and the challenges that we may face.
Using ESG to drive long-term returns
Using ESG to drive long-term returnsTherese Niklasson, Global Head of ESG, Investec Asset Management Naasir Roomanay, ESG Analyst, Investec Asset Management
The impact of Environmental, Social and Governance (ESG) issues has become more obvious as the physical risks of climate change become clearer, social movements around inequality gather momentum and corporate governance concerns have become more pressing. We believe that to fulfil our fiduciary duty we must properly consider these issues to determine the risks that they may pose, or the value they may add, to our clients’ capital.
The financial services industry is increasingly aware of the long-term impact that ESG issues may have on the value of investments. As a result, financial services companies, like Investec Asset Management, are building internal capabilities to assess ESG factors and integrating them into investment processes. The graph below shows the growing assets under management of signatories to the UN Principles for Responsible Investment. From the programme's inception in 2006 to April 2016, signatories’ assets under management has risen from US$4 trillion to more than US$62 trillion.
Source: PRI Association
Recent intergovernmental agreements, such as the December 2015 Paris Agreement on Climate Change and the 17 Sustainable Development Goals (SDGs), have accelerated investors’ growing interest in ESG issues. Leading executives, including our CEO, Hendrik du Toit, are engaged with new organisations established to develop solutions to the long-term ESG challenges raised by these global agreements. Hendrik is a member of the Business and Sustainable Development Commission, which seeks to articulate and quantify the business case for companies to help achieve the SDGs. As these issues move into the foreground, we see ESG as an institutional capability, and is central to many of our clients.
Embedding ESG issues in the investment process can uncover material investment opportunities. But investors and investment managers will likely scrutinise two approaches. The first, typically adopted in a strategy with shorter-term investment horizons, is the exploitation of mispricing of information on ESG events. Here, ESG events refer to material events such as the 2015 Volkswagen emissions scandal, the 2012 shootings at the Marikana platinum mine in South Africa, or the collapse of Lehman Brothers in 2008.
Where company analysis reveals that ESG risks have been overlooked or mispriced, there may be an opportunity to buy or sell its shares, with the expectation that the stock price will correct when the market factors in the risks. However, these risks are complex and may not have an impact in the forecastable future, which make them difficult to price. For example, investors are currently grappling with the complex risk of climate change where the financial impact is becoming clear, but we have yet to fully understand what it might be.
Investors may also make short-term gains by taking positions based on information they receive before it becomes common knowledge. For example, the emissions-test rigging scandal that engulfed Volkswagen, when a non-governmental organisation, the International Council on Clean Transportation, brought to light news of emissions rigging before it hit the main press. In such cases, the availability of information and data, and the speed at which it is delivered is vital to taking advantage of opportunities. But will the benefit of mispriced information disappear as investors increasingly integrate ESG factors into their investment processes?
The longer-term approach to identifying opportunities is through corporate engagement, or active ownership. This involves a skilled team engaging with companies on ESG matters to drive change in a company’s processes or policies. Recent research by London Business School, Boston College and Temple University in Philadelphia analysed corporate social responsibility engagements with US public companies between 1999 and 2009. The study found that companies where there were successful engagements showed higher positive abnormal returns, as shown in Figure 2.
The analysis suggested that the market responded positively to successful engagements partly because firms improved their operating performance and corporate governance practices.
These opportunities are becoming a mainstream focus for large institutional investors. But there remain three major challenges: limitations to the investible universe; variable data and ratings quality; and developing new stock selection techniques.
Shrinking the investment universe
Negative screening – excluding a company for engaging in a particular industry or practice – was one of the first forms of responsible investment strategies. But the definition of “negative” in this context is difficult to pin down. This process traditionally only screened for tobacco, weapons (particularly those considered to be indiscriminate such as cluster bombs and chemical weapons), and other sin stocks. But negative screening now also includes companies that have poor ratings on new ESG indices developed by major index providers including MSCI and FTSE Group. In certain markets, such as South Africa, this may imply a smaller universe of investible securities, which may be disadvantageous to both investors and investment managers. Does this then mean that benchmarks should be adjusted as well?
Trusting the data
“Do Ratings of Firms Converge? Implications for Strategy Research”, a 2014 study for the Institute for Research on Labor and Employment at University of California, Berkeley observes the divergence of ratings by various ESG ratings providers for the same companies. The study cites differing definitions of sustainability, as well as measurement methodology. Looking ahead, this discrepancy may have significant implications for many stakeholders’ data comparability and portfolio-level scoring. Discrepancies between providers makes it hard for investors to make allocation decisions based on these metrics. Will the industry move towards a common, standardised ESG measurement framework?
How to select stocks for ESG?
Investors can take advantage of opportunities from investing in both companies that well and poorly rated on ESG indices if they have skilled investment professionals and engagement teams. In this case, corporate engagement is necessary for improving sustainability considerations over the long term. The challenge is integrating ESG considerations into the stock selections process, and its implications for portfolio optimisation. Where will investors draw the line when allocating across the ESG spectrum?
As investors pay greater attention to sustainability and ESG considerations, they may fundamentally change the criteria by which they select investment managers, the type of information they require, and the management fee structures they will accept. Ensuring that investment analysis includes a detailed consideration of ESG factors will be key to identifying opportunities. But these considerations, while they appear to feature in individual investment products, are actually a result of deeper integration with traditional investment analysis.
But where are the next big opportunities?
So-called impact investing is one area currently in the spotlight -- although there is no widely accepted definition of the “impact”, such as intended outcomes or measurement techniques for monitoring the social benefit of the investments. There is mounting interest by asset owners in understanding how invested capital can alleviate social issues. We see the rise of impact investing as part of a broader need to modify traditional capitalism. The current system has not yet provided effective answers to the intransigent global problems caused by the financial crisis and has not yet found a way to effectively mobilise funding to deal with the challenges of climate change or growing global inequality.
Interest in green bonds is also gaining momentum particularly for sustainable infrastructure projects. Several governments and supranational organisations have issued bonds to fund these developments. The World Bank alone has issued US$8.5 billion of green bonds since 2012. Thematic green bonds is another area of growth. These are bonds issued to fund projects focused on addressing a specific global challenge, such as climate change. According to the Climate Bonds Initiative, institutions issued US$41.8 billion of green bonds in 2015. An almost fourfold increase from US$11.5 billion in 2013.
The Paris Agreement and the SDGs are both important developments, with significant focus on the role and impact of capital markets on sustainability issues. The Paris Agreement in particular sets precedence for other thematic sustainability issues, and its success may provide all stakeholders with a framework for addressing global issues. The SDGs and Business and Sustainable Development Commission will hopefully provide the necessary incentives to investment for a more sustainable future.
Therese Niklasson is Investec Asset Management’s Global Head of ESG; Naasir Roomanay is an Analyst in Investec Asset Management’s ESG Research team
 Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership (August 7, 2015). Review of Financial Studies, Volume 28, Chapter 12, pp. 3225-3268, 2015