Investing has always been a blend of science and art – environmental, social and governance (ESG) factors have been lumped somewhere in the middle. But this is changing as asset owners broaden their ESG lens from niche sustainable or ethical investment options to capture their entire portfolio.
It marks an evolution rather than revolution as many large asset owners still offer sustainable investment options.
More than $30 billion resided in various ESG investment options at the end of 2018, representing a 37% 1 increase on the previous year. However, almost half of Australia’s $2.8 trillion in superannuation savings are now overseen by funds and investment managers that follow ESG investment principles.
Those that don't may well find themselves increasingly being asked 'why not?' by members and investors. About one in 10 signatories to the UN Principles for Responsible Investment were placed on a watch list last year for failing to abide by its minimum standards of responsible investment activity.
A recent global survey by Natixis Investment Managers 2 found that seven in 10 individual investors believe it is important to make a positive social impact through their investments.
Regulators such as APRA are also pushing institutional investors to consider environmental factors such as climate change. Meanwhile Royal Commissions into the financial services and aged care sectors have highlighted the damage caused by poor governance and illustrated growing community expectations for businesses to act ethically.
The ESG impact on investment returns
Each element of the ESG equation has a different relationship with the sole purpose test, limiting funds’ actions to those that boost member retirement benefits.
Many members feel strongly about the importance of ESG factors but not so strongly they will pay higher fees or suffer lower investment returns (although the evidence suggests an ESG lens is a positive long-term factor on returns rather than a negative).
Some ESG processes clearly benefit the bottom line. For example, one major asset owner working with J.P. Morgan has been able to save its members millions of dollars by implementing an energy monitoring system across its property portfolio. This allowed it to slash unnecessary energy usage, such as air conditioners running too cold or hot, within the many buildings it owns.
However, not all ESG benefits are immediately obvious in the short-term using financial metrics.
A recent APRA survey 3 found that slightly more than 40% of surveyed super funds considered climate change to be a material financial risk today while a similar same proportion said it was not a material risk but thought it may become so in the future. The regulator has called on super funds, banks, and insurers to not just gain awareness of the financial risks of climate change, but to take action.
While sustainable options typically don't invest in companies heavily involved with fossil fuels, there's a counter argument that asset owners can make a greater change by engaging with those companies.
Engagement rather than divestment is a rising trend that is also a positive for returns. It is implicitly supported by new legislation such as the Modern Slavery Act, which encourages transparency as a way to boost more sustainable corporate practices.
Better data and technology
ESG is becoming broadly embedded across capital markets, but there is still some way to go before we achieve a standardised global framework that supports fair comparisons. Companies use alternative reporting metrics while data vendors gather different data points and use varying labelling standards.
For example, only 1% of auto, pharmaceutical and food companies fully disclosed their product safety recall incidents last year, forcing media companies and NGO to data mine text to get that information.
While asset owners are embracing ESG, many fund managers still have room for improvement. Obtaining ESG data from external managers, particularly in private equity and hedge funds, continues to be challenging.
Asset owners are using different methods to ensure their managers reflect their ESG priorities such as applying pressure during periodic operational due diligence reviews, stopping ongoing cashflows, or refusing to take part in future private equity fund raisings.
The culture of funds management is continuing to change as expectations grow that taking ESG factors into account is simply a core part of managing money.
1 Rainmaker, Australians among the most active ESG investors globally
2 Natixis Investment Managers, Looking for the Best of Both Worlds
3 APRA, Climate change: Awareness to action