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Responsible investing through ESG lens

Responsible investing through ESG lens
November 19, 2020

The infamous $100 billion company of 2000, Enron Corporation, was named “America’s most innovative company” for six consecutive years before it declared bankruptcy in 2001. It was revealed that the company was practicing systemic and creatively planned accounting fraud. It also caused dissolution of its auditor, Arthur Andersen. Enron was part of the respected Domini 400 Social Index, and also the nation’s oldest socially responsible fund– the Pax World Balanced Fund, which had Enron as a top holding. So, how did ethical investing professionals got entangled with such an unethical company?

This had made the Social-Responsibility Investing (SRI) Funds community to revisit the drawing board and do a postmortem. Concerns were raised about the accounting practices as well as the roles of auditors and board members. The caveat to the investor was that just because a company shows up on the SRI index does not mean it is a good investment. The Calvert SRI Fund was holding Enron in its portfolio even though they had raised the concerns to Enron about its environmental impact and human-rights violations. Enron officials showed no willingness to address the problems. It had eroded investment value for many of the investors.

Even today, though there has been increase in vigilance, cautiousness, and regulations, the scandals are an everyday affair. To refer to a few more famous examples– the 2010 BP Deepwater Horizon oil spill into the Gulf of Mexico, known to be one of the worst environment disasters, still continues to adversely affect the marine life there. The 2012 LIBOR scandal in which many of the WHO’s global banks were involved, was another example. In 2015, Volvo was found guilty by the US Environmental Protection Agency for cheating emission tests. The 2016 Wells Fargo account fraud was another instance. The 2018 Facebook-Cambridge Analytica data scandal changed our ideas about data security. The 2019 WeWork IPO disaster was another example. The 2019 Johnson & Johnson baby powder recall by the FDA after discovering cancer-causing mineral in the constituents falls in this category too. These scandals are just a few from the plethora of environmental, social, and governance (ESG) violations.

In the investment world, such ESG issues have created huge negative impact on the asset owners’ investments and the reputation of the asset managers. Due to such unethical cases getting reported on a regular basis, investors are increasingly looking to align themselves with companies that are transparent in their business practices and serve a greater social purpose. While ideally there are no perfect companies, the need is to look for companies that are heading ahead with positive ESG investing, also known as sustainable investing, and ensuring their sustainability and improved ethical impact over the long term.

Companies those protected their labor forces and supply chains during this year’s stock-market drawdown saw more net inflows from institutional investors and delivered better returns than their industry peers.

Illustrative ESG Focus Areas


Environment Social Governance
  • Carbon emissions
  • Deforestation
  • Air and water pollution
  • Energy efficiency
  • Waste management
  • Resource depletion
  • Data protection and privacy
  • Gender diversity
  • Customer satisfaction
  • Human rights
  • Employee and community relations
  • Working conditions
  • Board structure and executive compensation
  • Whistleblower policy
  • Corruption and bribery
  • Lobbying and donations
  • Audit committee

 

Over time the definition of ESG investing has come a long way from the relatively traditional social responsibility investing to the recent sustainable investing. The term “social responsibility investing” dealt more with avoiding investments in morally questionable ventures like cigarettes, liquor, and mining, to name a few. Sustainable investing, on the other hand, refers to identifying investment risks and opportunities using ESG analysis and ESG scores.

In the current times, these terms are being used interchangeably in investment analysis with a common emphasis on ESG issues. Investors intend to consider ESG issues for various reasons; some link them to ethical values and some look at it as more related to economic value. For example, an investor influenced by ethical value may not prefer investing in a tobacco company as they believe smoking negatively impacts society and the environment. In contrast, some other investor may see economic value in a tobacco company and might use the ESG analysis and ESG scores to complement the traditional investment analysis.

Taking cognizance of social, environmental, and economic challenges, the United Nations in recent years has set up 17 Sustainable Development Goals (SDGs) with an aim to achieve a more thriving economy focused on long-term wellbeing of people and the planet. This aim is also seen as the base for ESG guidelines and research. Its successful implementation requires collaborative action among countries, governments, companies, and investors, and can lead to truly sustainable investing.

The Trend

Due to increase in investor education, social awareness and regulatory mandates, the investors now expect companies to align their business with ESG investing, i.e. the greater good of the community they serve. Investors believe that the companies by addressing issues related to environment sustainability, employment relations and safety, gender diversity, corruption, and more such issues, have greater chances of long-term success.

Institutional investors like retirement and endowment funds are also increasingly opting for ESG funds. In a recent study done by State Street Associates researchers and HBS Professor George Serafeim, it was found that companies that were able to maintain employee moral, loyalty and engagement, protect supply chains saw their stock price performing better than their competitors.. State Street also recently launched an ESG version of its popular ETF. It is evident that ESG funds are on the rise.

In Q1 2020, as the COVID-19 crisis widened globally, investors poured $45.6 billion into ESG funds while $384.7 billion flowed out of the overall fund universe. By the end of March 2020, the total assets in sustainable funds stood at $841 billion, down 12% from its 2019 end-peak of $960 billion. On the other hand, assets under the wider fund universe took a greater hit with 18% decline due to COVID-19. The latest study from Blackrock has shown that in Q1 2020, 94% of widely analyzed sustainable stock indices have outperformed their benchmarks.

Fig 1. Worldwide increase in UN-PRI signatories in 2018/19 vs 2017/18

Worldwide increase in UN-PRI signatories in 2018/19 vs 2017/18

A trusted indicator of the increase in awareness of ESG issues is the rapidly growing list of signatories to the United Nations’ Principle for Responsible Investment (PRI). According to PRI, there are currently over 3,200 registered signatories; that includes investment managers, asset owners, and service providers.

Fig 2: There is rapid expansion seen in the ESG and value-based ETF market

Worldwide increase in UN-PRI signatories in 2018/19 vs 2017/18

Accelerated growth has been witnessed in the creation of ESG- and value-based ETFs, with assets reaching $93.9 billion.

According to multiple studies done by Morningstar and S&P Global, investments in companies with high ESG scores and funds that invest in those companies tend to outperform other companies

Future Progress and Changes in Core Investment Culture

Several benefits can be derived by applying the ESG aligned goals in the businesses– better corporate governance, employee relations, and working conditions generally lead to better employee retention and engagement. Following sound standards for financial processes leads to lesser audit scrutiny and compliance investigation. Better resource planning and decreased waste as part of the value chain can reduce the operating costs, thus enhancing profits.

Good ESG quality can help a company develop a competitive advantage, which can then drive sustainable products, higher returns, and improved performance. It is in the best interest of companies and investors to implement sustainability considerations into their decision-making processes.

ESG investing is gaining popularity as the investment flow into the funds accelerate, particularly in the equity and fixed income funds category. The asset managers would be under increased pressure to ensure that the ESG funds are being utilized for the best suited purposes. The investors would be eager to know how the ESG principles are getting integrated in the investment process and offer clarity in its outcome. As the pressure grows, there are challenges which asset managers will have to deal with:

  • The ESG landscape is large and complex, this would need asset managers to thoughtfully select the right applicable ESG areas for their funds
  • Building in-house ESG research competency or sourcing externally
  • Absence of standard EGS terms, metrics, and reporting guidelines
  • Inconsistent ESG disclosures from issuers, leading to valuation risks
  • Designing and adopting the ESG research framework, and integrating it with their overall investment process
  • The ESG regulations are evolving and so are the forms of risk, and regulatory reporting
  • Influential dialogs on ESG initiatives and its adherence with the corporations might be a slow affair as passive funds continue to be a part of the bigger flow of investments in the corporations.

Lastly, the ESG research covers companies across businesses, sectors, geographies, and themes; thus, necessitates handling and analysis of huge volumes of data across various financial and non-financial indicators. This data is over and above the traditional research data and will have to be sourced from multiple external sources and providers. The coverage, quality, and integrity of this data will need certification. The ESG research might need to probe the alternative source of data. The challenge would be to integrate this data with the traditional data in the asset management systems for valuation, portfolio construction, portfolio performance analysis, compliance, risk analysis, reporting, and predictive modeling.