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Socially responsible investing has been a theme in the global financial markets for decades. Some institutional investors use negative screens to exclude sectors like tobacco or alcohol, while others strive to support sustainability through investments in renewable energy, community housing, microfinance and other fields.
Today, a growing number of institutional investors and asset managers are focusing on integrating a company’s environmental, social and governance (ESG) policies and practices with traditional financial analytic tools.
“We see ESG factors as a vital aspect of the investment decision-making process,” says Cindy Rose, Head of Responsible Investing — Stewardship, Aberdeen Asset Management PLC. “Over the longer term, companies that manage their ESG opportunities and risks, along with their financials, will have a competitive advantage.”
One indicator of that positive differential is the MSCI Emerging Markets ESG Leaders Index, which provides exposure to companies with high ESG performance relative to their sector peers. It has consistently outperformed the MSCI Emerging Markets Index for the past nine years. Through July 2017, the ESG index rose 13.83 percent compared with 11.6 percent for the non-ESG index.
“Many investors are still looking at screens and traditional social responsibility investing,” Rose says. “But the real value comes through ESG integration, which can provide you with a better understanding of the value of the asset and the price you should pay.”
“Sustainable investing is one of the fastest-growing segments in finance right now,” says Michael Baldinger, Head of Sustainable and Impact Investing, Managing Director, UBS Asset Management. Indeed, the sector almost doubled in size from $14 trillion in 2012 to $22 trillion in 2016. Geographically, about two-thirds of the demand is coming from Europe, where institutional investors typically ask managers to show how they are integrating ESG across their asset classes, says Baldinger. While the U.S. now lags behind, demand is growing three times as fast as Europe, and within a few years it will likely be the largest market.
Baldinger adds that Japan is the fastest-growing market in Asia, although there is a pickup in China as well.
“Many Chinese companies now have ESG policies and disclose their ESG actions,” says Ruby Lv, Marketing Director, SynTao–Sustainability Solutions in Shanghai. “The Hong Kong stock exchange requires listed companies to disclose ESG information. If a company doesn’t do it, it must explain why it chose not to disclose.”
Another indicator of global interest in ESG is the growth of the UN Principles of Responsible Investing (PRI), which fosters good governance, integrity, and accountability in the financial markets. In the first quarter of 2017, 79 new investors joined PRI, bringing the total of signatories to 1,600.
There are several reasons for the worldwide growth in demand for ESG strategies, including the desire for greater transparency, says Baldinger. “Institutional investors are looking for ways to understand the inner workings of a company beyond the traditional financial analysis.”
In-depth ESG research can identify potential revenue drivers, such as innovation, that may not be immediately obvious on the balance sheet. It can also help investors seeking to mitigate risk, such as disruptions to a supply chain, Baldinger says.
Another reason for growth is the implementation of new sustainability regulations in a growing list of countries. “Examples include France’s mandatory reporting of climate risk, which raises the bar for financial institutions,” Baldinger says.
In keeping with those regulations, many institutional investors are setting explicit targets for reducing the carbon footprint in their portfolio, or are targeting the overall long-term transition to a low greenhouse gas emissions economy, according to Baldinger “Long-term sustainability is a big theme for institutions, especially insurance companies and pension funds,” he says. “They want to understand how issues like climate change will affect the company’s assets in the future. As fossil fuels become more expensive and demand shifts to alternative energy, those trends will impact a company’s operations, creating both challenges and opportunities.”
One of the challenges facing investors considering allocations to the ESG sector is the diversity of terms, definitions and meanings. “There are many funds with ESG or SRI in their titles, but none of them are the same,” Rose says. A carbon-friendly fund, for instance, will have different characteristics than a no-tobacco fund. In addition, fund managers may use different methodologies for assessing the quality of an ESG investment.
Therefore, an institutional investor needs to drill down to see how an ESG or SRI fund’s strategy and underlying assets are aligned with its statement of principles, as well as financial objectives. “One pension fund might be focused primarily on sustainability, while another might prioritize governance issues,” Rose says. “That’s an important driver in the manager selection process.”
Reflecting the wide range of investor interest, understanding and commitment to ESG strategies, asset managers like Aberdeen and UBS offer different types of sustainability solutions. “We integrate material ESG considerations into investment decisions across our four asset classes, taking a risk-based approach when analyzing each investment,” Rose says.
UBS is among the asset managers that offer screens, integrated ESG analysis, and customized solutions to institutional clients. That includes innovative sustainable investing products, such as a climate-aware rules-based equities strategy, and an impact methodology for measuring portfolio impact on ESG.
“By committing to offer sustainable investment solutions that deliver strong returns, larger asset managers can play a key role in providing this value proposition to asset owners, thereby helping sustainable investment to become mainstream,” says Baldinger.
For institutional investors considering ESG strategies, Rose suggests the following best practices:
- Understand your own position with regard to ESG. “Has the investment committee adopted an ESG statement or statement or principles? That is a good first step in the process,” she says. “Knowing what ESG means to you is fundamental for making investment decisions.”
- Sponsors of defined benefit (DB) and defined contribution (DC) plans should stay in regular contact with their participants and beneficiaries. Use emails, surveys, and conferences to gather information. “Find out if your participants express concerns about certain types of investments, or want to focus on ESG investing,” Rose says. “If you make the decision at the board level, without gaining that feedback, you are likely to run into problems.”
- Use your statement of principles as the foundation for your manager selection process. “Ask for a robust explanation of how each manager integrates ESG into the offering,” she says.
- Ask fund managers for regular updates rather than taking a “hands-off” approach. Frequent communication gives investors a timely opportunity to understand what’s happening with the fund, as well as the overall sector.
- Ask how the manager interacts with the assets in the portfolio. “Along with understanding the risks and opportunities, we look at how we can engage with the company,” Rose says.
Finally, investors should resist the temptation to simply check a few ESG boxes in selecting a manager. “Avoid things that look like easy remedies,” Rose says. “There is nothing easy about this process. It may be fashionable to look at sustainable issues like climate change, but you don’t get much information of value without doing the research to understand the manager and the individual assets.” — Richard Westlund
ESG Investing Finds a Big Home in China
Don’t be surprised if the next driver you hail with a smartphone app in Shanghai pulls up in an electric sedan.
Financial support is pouring into Chinese electric car manufacturing, ride-hailing apps, bike-sharing, and other zero-emission ways of getting around thanks to booming investor interest in environmentally sustainable transportation. One result is that drivers-for-hire with electric cars are increasingly common in Shanghai.
Transportation is just one of many sectors now supported by ESG (environmental, social, governance) investors, asset managers, government policymakers, and a wide range of manufacturers and service providers in China. Solar power, elder care, water conservation, and eco-friendly, pre-fabricated buildings are also on the ESG agenda.
By 2020, the government plans to have increased clean energy's contribution to the nationwide energy mix to 15 percent and boost pre-fabricated housing to 20 percent of all new residential construction, according to Kevin E. Lee, Executive Vice Chairman at CMIG, China’s first ESG-focused investment group.
China's investment community is clearly on board. ESG and “responsible investing” conferences drew large crowds in recent months in Tianjin, and at a Beijing event sponsored by the Asset Management Association of China.
Meanwhile, the government has been promoting credit instruments called “green bonds” as a right-thing-to-do financing channel for environmentally friendly infrastructure projects, consumer product manufacturing, and power generation.
Not only are green bonds designed to support the nation’s fight against air, land, and water pollution by, for example, financing solar power stations, but they’re also backing companies whose products and engineering know-how can compete in the global marketplace.
A policy circular released in late 2016 by the government’s National Development and Reform Commission (NDRC), on behalf of the Central Committee of the Communist Party of China, put the onus on lower level governments in cities, counties, and provinces to support bond financing for infrastructure projects that protect nature and improve environmental conditions.
Local backing, NDRC said, should come in the form of various types of government support for projects financed with investment bonds.
“Local governments should actively guide social capital to participate in green project construction” through “investment subsidies, subsidy guarantees, bond discounts, fund injections and other means,” according to the policy. Building projects pegged as “green” can involve water conservation systems and industrial parks with low-emission power sources.
One example of ESG in action is a solar power and poverty alleviation project in western China’s Ningxia Hui Autonomous Region. Farmers who used to eke out a living in a desert are now raising sheep by taking advantage of pasture grass growing amid solar panels at the Ningxia Solar Farm. A CMIG division that’s building the solar plant also helped farmers finance sheep-raising businesses.
A recent report by Deloitte predicted Chinese government preferential policies will continue supporting green corporate bonds and similar ESG investment initiatives for the long term. Beijing wants “all types of financial institutions, securities investment funds and other investment products, the Social Security Fund, and corporate pension and social funds” to invest in “green companies, enterprises and other institutional investment bonds,” the report said.