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ESG Investing Practices Progress Challenges
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ESG Investing: Practices, Progress
and Challenges
Please cite this report as: Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris, oecd/finance/ESG-Investing-Practices-Progress-and-Challenges.pdf This work is published under the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of OECD member countries. This document, as well as any data and map included herein, are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. © OECD 2020
Foreword Forms of sustainable finance have grown rapidly in recent years, as a growing number of institutional investors and funds incorporate various Environmental, Social and Governance (ESG) investing approaches. While the mainstreaming of forms of sustainable finance is a welcome development, the terminology and practices associated with ESG investing vary considerably. One reason for this is that ESG investing has evolved from socially responsible investment philosophies into a distinct form of responsible investing. While earlier approaches used exclusionary screening and value judgments to shape their investment decisions, ESG investing has been spurred by shifts in demand from across the finance ecosystem, driven by both the search for better long-term financial value, and a pursuit of better alignment with values. This report provides an overview of concepts, assessments, and conducts quantitative analysis to shed light on both the progress and challenges with respect to the current state of ESG investing. It highlights the wide variety of metrics, methodologies, and approaches that, while valid, contribute to disparate outcomes, adding to a range of ESG investment practices that, in aggregate, arrive at an industry consensus on the performance of high-ESG portfolios, which may remain open to interpretation. The key findings of our analysis illustrate that ESG ratings vary strongly depending on the provider chosen, which can occur for a number of reasons, such as different frameworks, measures, key indicators and metrics, data use, qualitative judgement, and weighting of subcategories. Moreover, returns have shown mixed results over the past decade, raising questions as to the true extent to which ESG drives performance. This lack of comparability of ESG metrics, ratings, and investing approaches makes it difficult for investors to draw the line between managing material ESG risks within their investment mandates, and pursuing ESG outcomes that might require a trade-off in financial performance. Despite these shortcomings, ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation. It could also represent an important market based mechanism to help investors better align their portfolios with environmental and social criteria that align with sustainable development. Yet, progress to strengthen the meaningfulness of ESG Investing calls for greater efforts toward transparency, consistency of metrics, comparability of ratings methodologies, and alignment with financial materiality. Lastly, notwithstanding efforts by regulators, standard setting bodies, and private sector participants in different jurisdictions and regions, global guidance may be needed to ensure market efficiency, resilience and integrity. This report has been prepared to support the work of the OECD Committee on Financial Markets. It is part of a broader body of work to monitor developments in ESG rating and investing. The note and accompanying analysis has been prepared by Riccardo Boffo and Robert Patalano from the OECD Directorate for Financial and Enterprise Affairs. It has benefited from comments by members of the OECD Committee on Financial Markets, OECD colleagues Mathilde Mesnard, Geraldine Ang and Catriona Marshall, and has been prepared for publication by Pamela Duffin, Edward Smiley and Karen Castillo.
FIGURES
- Figure 1. Breakdown of US assets professionally managed
- Figure 2. Drivers of ESG investing
- Figure 3. BNP- Drivers of ESG integration
- Figure 4. ESG financial ecosystem
- Figure 5. Reporting frameworks referenced in stock exchange ESG guidance
- Figure 6. SASB materiality map
- Figure 7. TCFD materiality framework
- Figure 8. S&P 500 ESG ratings correlation for different providers,
- Figure 9. STOXX 600 ESG ratings correlation for different providers,
- Figure 10. ESG ratings and issuer credit ratings,
- Figure 11. Fund managers’ incorporation of hedge fund strategies for ESG investing
- Figure 12. ESG market coverage share
- Figure 13. Market capitalisation as share of ESG by region,
- Figure 14. ESG rating shift to a different score, 2013-
- Figure 15. MSCI Minimum variance frontier and price index with base value 100, 2014-
- Figure 16. STOXX Minimum variance frontier and price index with base value 100, 2014-
- Figure 17. Thomson Reuters Minimum variance frontier and price index with base value 100, 2014-
- Figure 18. ESG top and bottom quintile Alpha by different providers, US, 2009-
- Figure 19. Top and bottom ESG portfolios by provider, price index, base value 100, 2009-
- Figure 20. Average company market capitalisation by ESG score and by different providers,
- index, base value 100, US, 2009- Figure 21. Small and large market capitalised stocks by top and bottom ESG rating by three providers, price
- Figure 22. Provider #2
- Figure 23. Provider #3
- Figure 24. E,S,G pillars top and bottom quintiles comparison between providers, Alpha, 2009-
- Figure 25. Annualised Sharpe ratio by rating segregation for 5 different providers, World, 2009-
- Figure 26. Annualised Sharpe ratio by rating segregation for 5 different providers, US, 2009-
- Figure 27. E,S,G pillars annualised Sharpe ratio by rating segregation and provider, US, 2009-
- providers, 2009- Figure 28. United States annualised Sharpe ratio by small capitalised companies ESG segregation for two
- Figure 29. 10 years and 5 years annualised funds’ performance to Morningstar sustainability rating,
- Figure 30. Distribution of 300 sustainable funds performances (5 stars),
- Figure 31. Distribution of 300 low sustainability funds performances (1 and 2 stars),
- Figure 32. Relative performance of selected MSCI Indexes to MSCI ACWI Index
- Table 1. The spectrum of social and financial investing TABLES
- Table 2. ESG criteria
- Table 3. ESG criteria - major index providers
- Table 4. SSGA Assessment of R^2 of ESG ratings among major score providers
- Table 5. ESG sustainability investment styles
- Table 6. Compounded Annual Growth Rate for different financial metrics for different providers
Executive summary
Environmental, Social and Governance (ESG) Investing has grown rapidly over the past decade, and the amount of professionally managed portfolios that have integrated key elements of ESG assessments exceeds USD 17 trillion globally, by some measures. 1 Also, the growth of ESG-related traded investment products available to institutional and retail investors exceeds USD 1 trillion and continues to grow quickly across major financial markets. The growing investor interest in ESG factors reflects the view that environmental, social and corporate governance issues – including risks and opportunities -- can affect the long-term performance of issuers and should therefore be given appropriate consideration in investment decisions. While definitions differ regarding the form of consideration of ESG risks, broadly speaking ESG investing is an approach that seeks to incorporate environmental, social and governance factors into asset allocation and risk decisions, so as to generate sustainable, long-term financial returns. 2 Thus, the extent to which the ESG approach incorporates forward-looking financially-material information into expectations of returns and risks, and the extent to which it can help generate superior long-term returns, is the focus of this report. Over the past several years, considerable attention has been given to ESG criteria and investing, due in part to at least three factors. First, recent industry and academic studies suggest that ESG investing can, under certain conditions, help improve risk management and lead to returns that are not inferior to returns from traditional financial investments. Despite the recent studies there is a growing awareness of the complexity of measuring ESG performances. Second, growing societal attention to the risks from climate change, the benefits of globally-accepted standards of responsible business conduct, the need for diversity in the workplace and on boards, suggests that societal values will increasingly influence investor and consumer choices may increasingly impact corporate performance. Third, there is growing momentum for corporations and financial institutions to move way from short-term perspectives of risks and returns, so as to better reflect longer-term sustainability in investment performance. In this manner, some investors seek to enhance the sustainability of long-term returns, and others may wish to incorporate more formalised alignment with societal values. In either case, there is growing evidence that the sustainability of finance must incorporate broader external factors to maximise returns and profits over the long-term, while reducing the propensity for controversies that erode stakeholder trust. ESG investing has also recently garnered interest from the public sector, including central banks that have expressed support for ways to help transition financial systems toward “greener”, low-carbon economies. Numerous central banks in advanced and emerging market economies have committed to integrate ESG assessment and investing practices into some of their responsibilities, such as reserve management and supervisory practices including stress tests. Irrespective of the actual path of climate change, the decisions being made by corporations and financial intermediaries indicates that climate transition and physical risks will increasingly affect the financial sector and warrant inclusion in the assessment of financial stability. 3 In light of growing demand, the finance industry is creating more products and services related to ESG ratings, indices, and funds. Firms calling themselves ESG ratings providers have multiplied. The number of ESG indexes, equity and fixed income funds and ETFs are now in the many hundreds, and are continuing to expand. Investors can now engage in ESG investing through low-risk products such as
large differences in ESG ratings across providers may reduce the meaning of ESG portfolios that weight better-rated firms more highly. ESG ratings can be used in a multitude of different investment approaches, which tend to conform to five distinct forms. On one side, the least amount of complexity is through excluding certain firms categorically (e. moral considerations), and on the other side is full ESG integration into the very firm culture of investing, such that it becomes an integrate part of the investment processes. Approaches such as ESG rebalancing, Thematic Focus and ESG Impact can be found in the middle. The choice of the strategy will greatly influence the final performance of the investment. Notwithstanding the progress to move forward sustainable investing through broader use of ESG factors and scoring, there are a number of challenges that may hinder further development in this rapidly growing and promising area of the market. Key issues for further consideration relate to: (i) ensuring relevance and consistency in reporting frameworks for ESG disclosure; (ii) opacity of the subjective elements of ESG scoring; (iii) improving alignment with materiality and performance; (iv) overcoming the market bias; (v) transparency of ESG products alignment with investors’ sustainable finance objectives related to financial and social returns; and, (vi) public and regulatory engagement. Part II of the report endeavours to complement the industry developments and assessments presented in Part I, by providing an assessment based on academic literature and OECD analysis of ESG scoring and benchmark performance, based on ESG databases of different providers. In terms of descriptive statistics, the size of the ESG investable shows market penetration of ESG scoring is still low based on number of companies, but is much higher when measuring it by market capitalisation, which better represents the investable universe. This suggests that there is ample room for investing using exclusion and tilting approaches while maintaining a sufficient level of diversification. Also, there is evidence of an ESG ratings bias against SMEs for some providers, such that firms with much higher market capitalisation and revenues consistently receive higher ESG scores than those with very low market capitalisations. The predictive power of ESG scores is inconsistent, and there is evidence that while some high- ESG indices and portfolios can outperform the market, the same is true for low-ESG portfolios. Using different providers’ data, OECD secretariat found an inconsistent correlation between high ESG scores and returns, such that different providers lead to different results. This does not mean that all ESG portfolios underperformed the traditional market: however, many high-scoring ESG portfolios did underperform, and a number of low-scoring ESG portfolios outperformed the markets. The analysis also found that asset concentration associated with tilting portfolios toward high- scoring ESG issuers can, depending on the conditions, affect volatility, risk-adjusted returns and drawdown risk. Various combinations of constructed portfolios based on tilts that provide greater exposure to higher-scoring issuers often performed at or below traditional indices for periods of time. The results are consistent with portfolio theory in that, greater concentration of exposures in a given portfolio can increase volatility, all else equal On the contrary, the analysis of maximum drawdown risk showed that ESG portfolios have a lower drawdown risk when compared to non-ESG portfolios. There was little differentiation in the performance of funds with higher-scoring and lower-scoring ESG securities; the wide range of performance of funds across both categories indicates that a host of other factors, including particular investment strategies and their implementation, drive results. This result simply indicates that investors should not generalise about the potential financial returns of funds based on ESG scores, and also suggests the importance of investor education related to retail ESG funds. At the same time, there is no evidence that preference for high ESG funds leads to underperformance, as other investment factors can affect results.
The assessments from Part I and II suggest that, to unlock the potential benefits of ESG investing for long-term sustainable finance, greater attention and efforts are needed to improve transparency, international consistency and comparability, alignment with materiality, and clarity in fund strategies as they relate to ESG. There is ample evidence to believe that abundant information about relevant environmental, social and governance factors, if provided in a rigorous and consistent manner, could help investors make better decisions about portfolio constructions and expectations of financial returns. Part III reviews policy developments and considerations with respect to strengthening ESG practices globally. Policy developments across several major markets suggests that, while policy initiatives are at different stages of development, efforts are being made to strengthen ESG practices so that they are transparent, efficient, and fair. Regulatory initiatives related to sustainable finance, and ESG in particular, are spanning topics such as taxonomy and disclosure regarding issuers, ESG fund products and rating agency and benchmarks. In the EU the European Commission has assessed practices and implications of sustainable finance, moving ahead on an ESG regulatory framework and is about to unveil a Renewed Sustainable Finance Strategy, integral part of the European Green Deal, which will cover ESG data and ratings. Agencies and expert groups are prioritising sustainable finance to promote sustainable investments and reduce the risks associated with a missing framework, such as greenwashing. Initiatives in the United States are based upon the principles-based approach to overseeing disclosure of non-financial information by publicly-listed companies. The US SEC is engaging in consideration of ESG investing through several avenues, including recent steps regarding the review of ESG disclosure and the naming of funds with ESG (or similar) investment mandates.. Japan is also paying attention to ESG developments and in 2018 created a label to identify companies that are reporting on ESG performance, as part of efforts to improve corporate disclosure and improve the long-term investing landscape. More work has been done with respect to how institutional investors consider ESG factors. The assessment of ESG factors suggest that, notwithstanding progress to enhance data availability and analysis, further efforts by policy-makers, financial market participants and other stakeholders will be needed to strengthen ESG practices. Given the work in progress across regulatory bodies and financial markets is progressing in varying speeds and directions, the following high-level considerations would help bring global consistency to allow various constituencies to focus their efforts within and across markets. The considerations reflect 5 key areas, including: Ensuring consistency, comparability and quality of core metrics in reporting frameworks for ESG disclosure. Despite the efforts to improve ESG disclosure the reporting of ESG factors still suffers from considerable shortcomings that undermine its usefulness to investors. Ensuring relevance of reporting through financial materiality over the medium and long-term. Currently, ESG reporting and ratings approaches generally do not sufficiently clarify either financial materiality or non-financial materiality (e. social impact), so investors are lacking a clear picture of the issues that are likely to directly impact the financial condition of a company. Levelling the playing field between large and small issuers related to ESG disclosure and ratings. Research suggests that there is an ESG scoring bias in favour of large-cap companies, and against SMEs. This burden, may be due in part to the ability of large firms to dedicate more resources to reporting and poses a market inefficiency to the extent it affects both relative cost of capital and corporate reputation. Promoting the transparency and comparability of scoring and weighting methodologies of established ESG ratings providers and indices. Evidence indicates that major ESG providers’ outputs give rise to several challenges. A very low degree of correlation as to what constitutes a high or low-scoring
Introduction
Sustainable finance is generally referred to as the process of considering environmental, social and governance factors when making investment decisions, leading to increased longer-term investments into sustainable economic activities and projects. Its growth has been driven by the desire of investors to have an environmental and social impact, along with the economic performance of investing. This growth is a response to a larger trend which saw many countries around the world to mobilise efforts to contribute to a global improvement. Now finance is taking its active position in trying to implement these concepts in the investing practice. The instrument that was born from this will is the Environmental, social, and governance (ESG) rating, from which ESG Investing is developed. Environmental, social, and governance (“ESG”) investing has evolved in recent years to meet the demands of institutional and retail investors, as well as certain public sector authorities, that wish to better incorporate long-term financial risks and opportunities into their investment decision-making processes to generate long-term value. Among the long-term factors environmental, social and governance categories can include controversies and downside risks that have the potential to erode equity value and increase credit risk over time. As such, it aims to combine better risk management with improved portfolio returns, and to reflect investor and beneficiary values in an investment strategy. 4 In this respects, the investment community has come to consider ESG as an investment approach that seeks to incorporate greater and more consistent information regarding material environmental, social, and governance developments, risks and opportunities, into asset allocation and risk management decisions, so as to generate sustainable, long-term financial returns. 5 In addition, the approach can equally serve to aid investors and other stakeholders in their effort to use environmental, social and governance information for ethical or impact investing, in which financial returns are not the primary focus of the investors objective. In this regard, there is a rising demand by these investor types to improve the alignment of their portfolios with societal values, such as related to slowing climate change, improving socially just practices, and ensuring high standards of corporate governance. ESG disclosure is gaining in acceptance because it can provides a useful tool for issuers to assess and communicate their socially responsible practices, and for investors that seek to assess the potential for social returns in a consistent manner across companies and over time. In concept, over the medium-to-long term, issuers that take into account these societal issues are more likely to avoid controversies and improve their reputations, better retain customers and employees, and maintain the trust of shareholders during periods of uncertainty and transition. However, at the present time, the extent to which the current ESG practices are sufficiently unlocking material information that is accessible and utilised by investors in an effective manner remains an open question. Notwithstanding the vital importance of the societal alignment of investments, the promise of sustainable finance for long-term value is the focus of this report. As such, it aims to contribute to a better understanding of the extent to which ESG investment processes and practices are contributing to strengthening transparency and market integrity, and are delivering intended results. There is growing evidence that investors and financial intermediaries are increasingly factoring ESG assessments into investment decisions. As of 2018, the number of signatories of the UN Principles of
Responsible Investment (UN PRI) that commit to pursue ESG integration has grown to over 2 300 signatories among institutional investors. The top reason professional investors consider ESG-related information is not to derive reputational benefit but to determine whether a company is adequately managing risk and aligning its strategy for long-term returns. In more recent investor surveys, the pursuit of maximisation of financial returns and enhanced risk-management have been consistently highlighted as key motivating reasons for committing to ESG integration. 6 The growth of ESG has faced difficulties in entering mainstream investment strategies until recent years. This may have been due in part to investors' misperceptions that sustainable investment limits choice and compromises key financial objectives. However, the rapid growth and diversification of ESG funds and investment strategies suggest that the industry is undergoing a transformation. There is mixed evidence that ESG investing in some of its forms is able to provide a societal benefit without sacrificing financial returns relative to performance of traditional portfolios, yet the extent to which ESG can contribute to strengthening long-term value through the incorporation of an array of non-financial information would benefit from further assessment. 7 At the same time, ESG terms and practices have not been clearly defined, and meanings differ across stakeholders, particularly across borders. There appear to be several core approaches to ESG investing, including negative and positive screening (inclusion and exclusion), tilting portfolios aligned with ESG scores, and also ESG impact and integration practices. At the same time, these approaches are at times combined with investing strategies – such as alpha, momentum, and long-short – that could in turn alter asset selection in portfolios. Moreover, the lack of standardised reporting practices and transparency, and the difficulty of translating qualitative information in numerical information, creates a barrier in the proper integration of sustainability factors into investment decisions. The OECD has been involved in developing responsible investment in a number of ways. The OECD Guidelines for Responsible Business Conduct for Institutional Investors; a report on investment governance and the integration of ESG factors; and setting forth a consultation for supervisory guidelines on the integration of ESG factors in the investment and risk management in pension funds. Also, on environmental issues, the OECD has developed numerous papers on sustainable finance and climate change. Also, it recently issued a report on Social Impact Investment 2019, highlighting the impact imperative for sustainable development. In light of the growing questions regarding ESG practices, the OECD’s Committee on Financial Markets has explored the developments related to various market participants and influencers that are shaping ESG practices; the materiality of ESG disclosures; the usefulness of ESG ratings; and, performance of ESG indices and funds. As well, it has engaged with the industry to better understand practices, including the benefits and potential shortcomings that could undermine adoption. Challenges relate to transparency, consistency, materiality, and the ability of financial consumers to understand both the loose taxonomy and how it relates to portfolio composition, returns and risks. This is particularly relevant where investors have expectations that they are able to utilise ESG to align with financial returns as well as societal values related to environmental, social and good governance practices. This report covers the following topics: Part I maps ESG industry participants, ratings methodologies, and investment approaches. Section 2 provides an overview of the definitions of ESG investing, how it is differentiated from social investing and purely financial investing, and drivers of its growth. It explores the distinction between end- investors who find appeal in ESG approaches due to their desire to align their investments with societal values, and the pressures on professional asset managers who are tasked with delivering superior financial returns on an absolute or risk-adjusted basis. Section 3 briefly illustrates the ESG financial ecosystem, in terms of various market participants and other stakeholders involved in providing ESG information, ratings, indices, and investment products. It illustrates
ESG investing and the investment fund industry
ESG within the investment spectrum ESG investing exists within a broader spectrum of investing based on financial and social returns. On one side of the spectrum, pure financial investment is pursued to maximise shareholder and debtholder value through financial returns based on absolute or risk-adjusted measures of financial value. At best, it assumes the efficiency of capital markets will effectively allocate resources to parts of the economy that maximise benefits, and contributes more broadly to economic development. On the other side of the spectrum, pure social “investing, such as philanthropy, seeks only social returns, such that the investor gains from confirming evidence of benefits to segments or all of society, in particular related to environmental or social benefits, including with regard to human and worker rights, gender equality. Social impact investing seeks a blend of social return and financial return – but the prioritisation of social or financial returns depends on the extent to which the investors are willing to compromise one for the other in alignment with their overall objectives. Within this spectrum, ESG investing focuses on maximising financial returns, and utilises ESG factors to help assess risks and opportunities, particularly over the medium to long-term. What differentiates it from purely commercial investing is that it takes into account factors other than assessment of short-term financial performance and commercial risks to that performance. In this manner, ESG investing incorporates the risk assessment of long-term environmental, social and governance challenges and developments. Also, it appears to take into account, to varying degrees, some element of positive behaviour that aligns with limiting spill overs or otherwise protecting the environment, responsible business conduct on social /worker issues, and good practice in corporate governance. The extent to which ESG investment incorporates social impact in a manner that increases financial risks (volatility and tracking error relative to an index) or reduces expected financial returns, would suggest that it is more aligned with social impact funds. The distinction between ESG funds and social impact funds is still not clear, and there remains some ambiguity in the market that could be better addressed by the financial industry, third-party providers, and international organisations. This can be the consequence of the use of ESG ratings as a broader instrument serving different purposes for different investors. While some investors use ESG as a tool for risk management, some others use it to improve their position on sustainable finance in order to align with societal and impact issues. ESG financial ecosystem, ratings methodologies, and investment approaches
Table 1. The spectrum of social and financial investing
Philanthropy Social Impact Investing Sustainable and Responsible Investing 8 Conventional financial investing Traditional Philanthropy Venture Philanthropy Social Investing Impact investment ESG investing Fully commercial investment | | | | | | Focus Address societal challenges through the provision of grants Address societal challenges with venture investment approaches Investment with a focus on social and/or environmental outcome and some expected financial return Investment with an intent to have a measurable environmental and/or social return Enhance long-term value by using ESG factors to mitigate risks and identify growth opportunities. Limited or no regard for environmental, social or governance practices | | | | | | Return Expectation Social return only Social return focused Social return and sub-market financial return Social return and adequate financial market rate Financial market return focused on long-term value Financial market return only Social impact Social and financial Financial returns Source: stylised adaptation from OECD (2019), “Social Impact Investment, the Impact Imperative for Sustainable Development,” based on earlier versions from various organisations; for illustrative purposes only. Recent industry terminology acknowledges that as demand for ESG products reflect desire for long-term value as well as alignment with social values, the spectrum of sustainable finance funds include approaches that involve ESG exclusion, ESG inclusion, and also impact. 9 While the ESG approaches will be described later in this report, it is notable that impact investing is considered, along with ESG investing, as a sustainable form of finance, because it seeks to generate a positive social return that is measurable and reportable, alongside a financial return. In this aspect, the use of ESG metrics and approaches within both responsible ESG investing for long-term value, and sustainable impact investing that seeks social returns alongside financial returns rather to explicitly enhance long-term returns, remains a source of ambiguity that has contributed to the proliferation of ESG metrics and methodologies to serve dual purposes. 10 Several developments have contributed to growth of ESG investing, distinct from social impact and traditional financial investments. First, societal demands by non-investors: the transition from the shareholder to stakeholder model has challenged the notion that the firm only serves shareholders, as the needs of other stakeholders have encouraged the growth of corporate social responsibility in business and even government entities. This has invited reporting on issues that relate to good practices and standards that do not relate to short-term financial returns but are thought to contribute to long-term value, such as by strengthening reputation, brand loyalty, and talent retention. Second, greater demand by social impact investors for data related to E, S, and also G factors, related to good practices. Third, the demand by ESG investors through responsible investing to take a more sustainable perspective, which can both benefit from risk management elements of ESG and also better align with societal values. The implications of these distinct drivers are explored in the next section. ESG investing – market dimensions and drivers The growth of assets under management that incorporates some element of ESG review and decision- making has grown exponentially over the past decade. In the US, the current level of ESG investing is now over 20% of all professionally managed assets, at over USD 11 trillion. 11 In Europe, industry data related to a broader range of ESG practices suggests the level is over USD 17 trillion. Due to institutional and retail investors desire for pooled investments and liquidity, ESG investment fund and ETF has grown to Use of ESG metrics and methodologies
Surveys suggest that institutional investors and professional asset managers seek to use ESG primarily to compete on improved risk adjusted returns and risk management. A study of 120 institutional investors conducted by Morgan Stanley concluded that 70% have integrated sustainable investment criteria into their decision-making, and an additional 14% are actively considering it. 12 A 2019 survey from BNP of institutional investors and asset managers notes that over half of the respondents are seeking to integrate ESG due to improved long-term returns, followed by firm reputation. Less than 30% pursue this for altruistic values or diversification of product offering. 13 Also, ESG is being incorporated into other portfolio products, such as ETFs. A survey by Bank of America illustrates that growth in ESG smart beta strategies has been faster than that of many other types of strategies (though it is likely that this sharp growth is from a very low base). Moreover, at the current pace, some players expect ESG investing through funds and ETFs to grow to several trillion within several years.
Figure 3. BNP- Drivers of ESG integration
Source: BNP Other finance industry surveys indicate that drivers of growth in forms of ESG investing, and the rotation away from purely commercial investing, has been due to end investors’ desire to improve corporate and other issuers’ alignment with social and moral considerations (Figure 2). Only about 20% sought these strategies primarily for financial returns or reducing investment risks. 14 In terms of demographics, several studies show that Millennials are driving both current investing in ESG and impact investing, while Generation X is also strongly supporting this shift. These societal trends mirror a growing recognition of the importance of realigning global financial toward sustainability in two important ways that relate to climate change and ethical standards of development: Greater attention to the need for finance to better incorporate the potential impacts of climate change is increasingly influencing the behaviours of investors, financial markets and financial institutions. Following the Paris Agreement in 2016, various international bodies have assessed the need for international finance to support the transition to low-carbon economies by committing capital to modernising infrastructures, renewable energy, and away from brown industries. 15 In this respect, the OECD has estimated that nearly USD 7 trillion a year is required up to 2030 to meet climate and development objectives. 16 This report recommended that authorities take steps towards a more climate-consistent global financial system by assessing and addressing possible misalignments within financial regulations and practices, improving the ability of markets to price climate change risks, and assessing the risks climate change poses to financial 20% 26% 27% 27% 32% 33% 37% 47% 52% Diversification of the product offer* Board/activist investor pressure Altruistic values Attraction of new talent External stakeholder requirement Regulatory/disclosure demands Decreased investment risk Brand image and reputation Improved long-term returns *option for asset manager respondents only Please rank (1-3) why you incorporate ESG into your investment decision-making
stability. Subsequently, a number of central banks in OECD member countries have turned their attention to the potential impact of climate change on the global financial system. A recent report by the Network for the Greening of the Financial System, comprised of these central banks and observing members such as the OECD, highlights the ways that ESG, among various tools for green investment, can be used by central banks in reserve management to help steer investments to better align with low-carbon economies. 17 The societal demand for higher ethical standards of economic growth through finance and business practices is also contributing to greater demand for ESG tools that can help measure and benchmark these practices. A key set of standards for ESG, and particularly the Social pillar, is the UN Global Compact, which highlights ten principles related to ethical standards related to human rights, labour, anti-corruption, and the environment. The OECD’s due diligence guidelines for responsible business conduct helps businesses contribute to economic, environmental and social progress, especially by minimising the adverse impacts of their operations, supply chains and other business relationships. 18 It includes human rights, employee and industrial relations, environment, combatting bribery, and consumer interests. Moreover, investors that seek to align investment strategies with ethical global development objectives, such as the Sustainability Development Goals, are seeking investment products that can help to improve alignment. 19 Metrics related to ethical standards, including these UN and OECD guidelines, are incorporated in some frameworks for ESG assessment so that investors are able to assess and compare behaviours of issuers when making investment decisions. Notwithstanding this welcome progress, the sharp growth of ESG investing has brought with it a growing number of participants that influence the creation of disclosure frameworks, ESG metric, ratings methodologies, and products from funds to indices. As forms of ESG investing continue to grow and proliferate, differing motives and lack of clarity over the specific types of investing that utilise ESG metrics and methodologies may be contributing to emerging challenges related to consistency and comparability, which risk undermining ESG meaningfulness and integrity. The next section seeks to explore these actors and behaviours in more detail.
ESG financial ecosystem
The growth and institutionalisation of ESG approaches and methodologies calls for a thorough understanding of the various contributors that have contributed to the institutionalisation of the ESG financial ecosystem. This ecosystem, as illustrated in the diagram below, includes issuers and investors who disclose and use information related to environmental, social and governance issues. As well, of focus in this note, is (i) an intertwined network of financial intermediaries and analytical service providers, and (ii) an array of non-government government, private sector and international organisations that are influencing the emerging practices in ESG investing. This section explores the key actors, the role they play, and how the activities bring benefits by contributing to a much greater amount of forward-looking information that benefits financial and social investors alike. Moreover, it has the potential to better align strategic asset allocation that contributes to enhanced long-term value while incentivising responsible business conduct among issuers. At the same time, ESG practices remain at a relatively early stage of development, and the activities of various institutional participants that develop or utilise frameworks and metrics have yet to arrive at common globally consistent terms and practices.
ESG Investing Practices Progress Challenges
Course: Introduction to business (MBA1)
University: Thapar Institute of Engineering and Technology
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