ESG Yields Profits
By Ron Robins
When I started my career as an investment analyst in 1970, the idea that a company′s environmental and social activities would be important in helping predict its future financial and stock performance was seen as largely irrelevant. Well, not anymore!
Inclusive of governance issues and abbreviated as ESG (environmental, social and governance), factors pertaining to ESG are now included in mainstream corporate stock and bond analysis in numerous investment firms, funds and managers globally. Why? Because it provides analysts better insight into companies and a possibility of producing higher investment returns with less risk.
ESG has its beginnings in ethical and socially responsible investing (SRI), which have their roots in some religious traditions. Now, with mounting environmental and climate change concerns, ‘green′ or sustainable investing has emerged. It was with these asset classes that ESG issues first began to play a pivotal role. However, ESG issues are now becoming a significant factor in all asset classes.
Evidencing the enormous shift towards inclusion of ESG issues in investment analysis among global financial institutions, were the findings reported in a September 14, 2010, press release of the United Nations (UN) Principles for Responsible Investment (PRI). The PRI is a “framework to help investors achieve better long-term investment returns and sustainable markets through better analysis of environmental, social and governance issues in investment process and the exercise of responsible ownership practices.” Companies sign on as signatories to the PRI framework.
In the PRI press release, Executive Director James Gifford said, “every large, world-class listed company is now monitoring and reporting on its ESG performance, and so too are an increasing number of investors.” The PRI reported that, “total [PRI] signatory numbers has jumped in the last year by more than 30 per cent. The value of the assets under management of PRI signatories now stands at $22 trillion, over 10 per cent of the estimated total value of global capital markets.”
Continuing, “signatories are now drawn from 45 countries. Over 95 per cent of asset owners and 87 per cent of investment managers have an overall investment policy that addresses ESG issues… The percentage of asset owners involved in dialogue with regulators on ESG issues rose to 85 per cent.”
And governments and regulators everywhere are listening. Countries that are taking big steps in promoting ESG issues in corporate reports include the USA, the UK, France and Sweden. Also, the European Union might soon have a policy for all member countries on ESG corporate reporting as well.
Even stock exchanges are becoming proactive on ESG issues concerning their listed companies. For instance, in South Africa, the Johannesburg Stock Exchange became the first exchange to require all listed companies to produce fully integrated financial and ESG reports. In Malaysia, its major stock exchange, the Bursa Malaysia, actively pursues ESG reporting among its listed companies.
As a result of such interest, especially by global investment institutions and individual investors, ESG stock and bond indexes are becoming commonplace everywhere. All the major stock/bond index producers—Dow Jones, FTSE, MSCI, S&P etc.—have global, continental, country and often even industry specific ESG stock indexes.
Encouraging the ESG cause are studies demonstrating improved financial, portfolio and stock performance where ESG factors are analytically applied. One study, published in March 2009 is by risklab, a division of Allianz Global Investors. It is “â€¦ a landmark study [that] strengthens the position of ESG advocates. The results reveal that a focus on ESG (environmental, social and corporate governance) factors can significantly reduce portfolio risk or enhance returns. The study is the first systematic quantitative analysis explicitly examining ESG risk in a portfolio context [it] concludes that investors ‘not only have a right to feel good about promoting ESG, but that clear financial benefits can be expected.”
Another study finds that, “[ESG] improves portfolio diversification through a reduction of the average stock′s specific risk â€¦ESG criteria probably leads best-in-class ESG screened funds to be better diversified than otherwise identical conventional funds pension funds should at least contemplate about the use of ESG criteria, as an ignorance of ESG criteria could violate their fiduciary risk management duties.” (From, Portfolio Diversification and Environmental, Social or Governance Criteria: Must Responsible Investments Really Be Poorly Diversified? By Andreas G. F. Hoepner of the University of St. Andrews, School of Management, Principles for Responsible Investment, UN.)
And a third study also by risklab, reported in Global Pensions on April 18 found that ESG can reduce the risk of negative or ‘tail′ risk impacts on portfolios in emerging as well as developed markets. “The tail risk of an ESG risk neutral emerging market equity strategy defined by the MSCI Emerging Markets Index can be reduced from -64.5 per cent p.a. to -38.8 per cent. The same is true for corporate bonds defined by the Merrill Lynch Global Broad Market Corporate Index, it added, where the tail risk—measured as conditional value at risk (95 per cent) of the default strategy—can be reduced from -8.1 per cent p.a. to -4.9 per cent… [and for developed market equity, the] tail risk optimisation potential of the ESG neutral default strategy defined by the MSCI World Equity Index [went down] from -38.1 per cent p.a. to -25.7 per cent.”
With increasing social, environmental and climate change risks, it makes dollars and cents to now include ESG issues in investment decisions. And that is why asset managers and investors everywhere are adopting ESG criteria in the selection of individual stocks and bonds as well as aiding in their structuring of entire portfolios.
May 24, 2011