ESG. This acronymhas been gaining strength and importance throughout the European institutions’ agendas and across industries, both locally and globally. Even if you’ve only heard the term in recent years, this pillar towards a greener economy has been around for a while. How did ESGs move from being niche criteria to mainstream in the past years?
The answer is simple. The success of ESGs and their growing importance reflect the increasing awareness of investors of the environmental and social consequences of corporate and government decisions. These consequences – from human rights abuse, negative environmental impact, to poor governance and gender inequality, companies and institutions – are now a main concern for businesses who try to include countermeasures in their agenda.
There is also a deeper understanding of climate change and its growing consequences, not only in an environmental perspective but also social and demographic. There’s a clear need for investment models to better fit investors’ concerns as responsible investors increasingly encourage responsible corporate practices. The financial industry continues to create new and innovative investment tools and products for investors and companies. Investors want the promise of a great financial engineering performance together with the assurance of a greener future.
As a result, there’s a high demand for integrating ESG criteria into investment decisions, not only in Europe but also in the US and Asia. Although market appetite for ESG is more recent in the US, according to the 2018 Report on US Sustainable, Responsible and Impact Investing Trends, in 2018 $11.6 trillion of all professionally managed assets were already part of ESG investment strategies, for example.
As the asset management industry continues to implement ESG criteria into their processes and investment decisions, creating new investing models and strategies, something is becoming clear: while they generate competitive returns, they also have a positive impact on a social and environmental level. Everyone’s a winner.
However, change is never easy and Rome wasn’t built in one day. European institutions have a full green agenda, creating new regulations and improving old ones, all part of a green future plan. But while the EU is the main regulator driver, it’s not the main driver of ESG implementation. Can you guess who the main drivers behind the rise of ESGs to the mainstream spotlight?
As you might have figured out by now, the main drivers of this change are investors, asset managers and regulators. But how do they do it exactly? Keep reading to discover how these three drivers are the kings of the road to a greener future.
From niche to global spotlight
What we have seen in past decades is a significant evolution in the field of sustainability. We went from Socially Responsible Investing (SRI), to social investment, sustainable investment, impact investment to ESG, which takes a broader approach to environmental, social and governance challenges. Back then, businesses that created a SRI product would exclude industries like alcohol, tobacco and fossil fuel production. Over time, it was seen as being a too narrow definition and it has evolved into a more sophisticated approach, combining several techniques:
Screening techniques like the Best-In-Class: the positive screening of the company asset managers want to invest in. The one with the best ESG scoring within their sector is chosen.
ESG integration. Asset managers would systematically integrate ESG considerations into their investment decisions. While analysing the ESG performance of the company in which you want to invest doesn’t mean you would necessarily exclude them, asset managers can take their chances with companies that show potential to improve on a sustainable level. By working together with the management of those companies (“engagement” or “active ownership”), asset managers take the most positive approach from both a portfolio and society standpoint.
Thematic investing: investing in a sector that is delivering positive impact on environmental or societal matters (renewable energies, green forest, organic, microfinance…).
Driving towards a greener horizon
Implementing ESGs is no longer just a mirage, but an oasis that must be integrated into the different level of business. Indeed, in the asset management industry, there are drivers pushing the boundaries of ESG implementation into core processes and investment decisions.
What we see is a combination of three strong drivers, pushing ESGs to the mainstream road across asset management and investment decisions for both asset managers and institutional investors.
1. The asset manager
ESG is now a key factor in their processes for various reasons. First of all, investor demand as we mentioned before. Asset managers are now realising that ESG criteria also contribute to the continuous uphill performance of their product. In the past, people and businesses had a limited understanding of ESGs as they were linked to the exclusion of certain sectors and the limitation of financial performance. Now, embedding the criteria in the investment decision could be a way to improve the “alpha” as well as to limit the risks linked to controversial activities. At the same time, if asset managers engage with the companies they invest in, they can motivate them to perform better from an ESG standpoint. The successful implementation of ESGs in investment decisions is increasingly reflected in their market price while contributing to better ESG risk management. At the end of the day, that means a better risk return.
Did you know?
Alpha is used in finance as a measure of performance. It’s often considered the active return on an investment, comparing the performance of an investment against a market index or benchmark, usually considered the representative of the market’s movement as a whole.
2.The investor
The demand for ESG products has historically come from institutional investors but this is changing. What we’ve seen for the past couple of years is the growing importance of addressing environmental issues, the 21st Conference of the Parties (COP21) being an example of that. This has driven the interest of investors, particularly the millennials towards the environmental, social and governance topics. To satisfy this demand, there’s a need for a product that takes into consideration the investors’ concerns and responds to the market demand for social responsible products. It’s up to the asset manager to develop the product and make it available to the investor, and for intermediaries to make the product available to the retail investor. Why is this happening now? Because there’s a strong demand from the market and the investor. Considering ESG criteria in the investment decision, asset managers contribute to a better ESG practice, while hoping it will generate a better financial performance with investors.
Did you know?
The Paris Agreement is an agreement between the leaders of over 170 countries to reduce greenhouse gas emissions and limit the global temperature increase by 2100. Each country that attended the 21st Conference of the Parties (COP21) agreed to cut its emissions by a particular percent based on a base year emissions level.
3. The regulator
We come back to the main regulator drivers: The European institutions. The European Commission initiated an action plan for sustainable finance to promote sustainable investment in Europe. Their agenda has three main objectives:
Finance the transition to a greener economy. The green horizon is in view but there are few roadblocks, mainly because public financing and banks loans aren’t enough fuel. To reach the oasis that is just beyond the horizon, the private sector needs to invest in a better future. A big part of the EC’s agenda is dedicated to encouraging sustainable investment and projects, like green energy and climate change.
Foster long-termism in the investment and asset management decisions. It’s about recognising that one of the causes of the financial crisis was the fact that investment decisions were taken with too many short-term views. There’s a need to think about the long-run and encourage long-term investment.
Monitor sustainability risks in the financial sector. There’s an increasing concern amongst regulators that the financial sector is far too exposed to risks, such as environmental. The question is, how do we ensure that across the financial sector the risk management process includes all these risks.
Did you know?
Long-termism is an actual word. It’s the practice of making decisions with a view to long-term objectives or consequences.
As the main drivers lead the way for an oasis with a greener horizon, it’s clear that Europe is the leading example when it comes to ESGs and sustainable investing, becoming the role model for countries like the US and continents like Asia. At the same time, all these drivers are an essential part of what is driving the current approach of the European Commission and the current different sustainable proposals.
What we think
Nathalie Dogniez, Partner at PwC Luxembourg
ESG isn’t a compliance exercise, it’s about the processes and transparency. It’s very important to engage with investors and for that, transparency reporting is essential. Indeed, the key to success from an ESG standpoint is to fully engage with the investors through very good investor reporting. ESG reports from asset managers explain in detail why they invested or disinvest in certain companies, and through their engagement policy how they have been helping these companies to improve their environmental, social or governance practices. It is a fantastic opportunity to engage with investors on a long term on common values.
If you want to learn more about the EU Action Plan on Sustainable Finance click here!
If you want to know more about the importance of ESGs, take a look at our video!
