The author of this article argues the case for ESG investing, and points to certain structural barriers to the trend, as well as a lack of consistent data in the field.

This news service continues to track the trend of what is called environmental, social and governance (ESG) factors in investing. The coronavirus pandemic accentuates certain aspects of this, such as showing why openness and transparency matter in how governments and corporations function. There is likely to be more focus on issues such as food production hygiene, the effect of global warming on the spread of diseases, or the ways that different groups in society are affected more harshly by viruses – and lockdowns – than others. People with “white collar” jobs who can work from home might suffer but not nearly as much as, say, a person in an emerging market country who cannot do their job from home. New inequalities are being formed. The “G” in ESG is arguably getting more attention: where do calls for more “track and trace” apps fit with ideas about privacy and how does that affect governance? 

ESG is a theme that is not going away, even if market gyrations and a certain amount of natural scepticism sets in after a period of time. Investors want to seek new sources of Alpha; they also want a clean conscience and want their wealth to mould the world in ways of which they approve. 

We have run several features about this topic in recent weeks, and will continue to monitor developments. In this article, Grace Chong, Of Counsel, at Simmons & Simmons JWS, talks about the subject. As always, the editorial disclaimers apply over the views of external contributors. Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

There has been a meteoric rise in interest in responsible investing. According to Morningstar, mutual funds and exchange-traded funds with a focus on sustainability raked in $20.6 billion of total new assets in 2019. The net money which flowed into these funds, which used environmental, social, and governance factors when investing, was  almost four times as much as in 2018, when it totalled $5.5 billion. 

An April 2020 analysis by S&P Global Market Intelligence, revealed that sustainable equity funds managed to weather the initial stage of the downturn better, on average, than conventional funds.

The top performer in the analysis, Brown Advisory Sustainable Growth Fund, had a negative 5.4 per cent price change in the year through market close on 9 April, compared with a 13.7 per cent decline in the S&P 500. 

Regulatory spotlight on ESG
ESG is by no means a new kid on the block. Concerns about sustainability and responsible investing have been around for a long time and managers have also been conscious about the governance of their investments for a while. However, the growing interest in this arena is set against a backdrop of global change.

Most notably, the Paris Climate Agreement of December 2015 brought all nations together for the first time to agree on taking co-ordinated steps aimed at strengthening the global response to the threat posed by climate change. This was also followed by the United Nations’ adoption of its 2030 Agenda for Sustainable Development, which set out 17 Sustainable Development Goals. The UN recognised that ending poverty and other deprivations must go together with strategies to improve health and education, reduce inequality, and spur economic growth - all while tackling climate change.

Some of the initiatives coming out of the European Union, such as the Disclosures Regulation, are also relevant for firms, regardless of whether they have an express ESG or sustainability focus. 

Furthermore, some of the emerging EU regulatory developments that require advisors to enquire about, and take account of, a client’s ESG preferences when establishing a mandate and making investment decisions in suitability assessments, may also ‘nudge’ retail and high net worth investors towards choosing ESG products. 

Most recently, the Council of the EU and the European Parliament agreed on the contents of an EU-wide classification system, or “taxonomy”, which will lay out exact activities that qualify as being environmentally beneficial, in order to provide businesses and investors with a unified lexicon regarding environmentally sustainable finance. It also defines the methodology for the 68 activities that qualify for substantial contribution to climate adaptation. 

Growing momentum in Asia
Closer to home, several regional and national initiatives have been undertaken which set ESG concerns as a central basis of regulation in the financial services industry.

In Singapore, the Monetary Authority of Singapore has announced that it is working on a comprehensive, long-term strategy to make sustainable finance a defining feature of Singapore’s role as an international financial centre. 

A key highlight has been MAS’ launch of a $2 billion Green Investments Programme with asset managers who are committed to drive regional green efforts from Singapore and support MAS’ action plan. Soon, it is expected that environmental risk management guidelines will be introduced to cover banking, insurance and asset management sectors. 

In Hong Kong in recent years, the regulators have also been gradually introducing more disclosure and reporting requirements. The Stock Exchange of Hong Kong has launched an ESG Reporting Guide, and the Securities and Futures Commission has released a Strategic Framework for Green Finance and a circular outlining requirements for public ESG funds. 

The focus on ESG themes is also expected to increase post Covid-19 in China, which has seen a push for ESG integration through the country’s regulatory and policy framework. ESG disclosures are expected to become mandatory under stock exchanges disclosure guidelines soon and, with the inclusion of certain A shares in MSCI Indexes, Chinese companies and asset managers now have a greater awareness of how ESG performance can impact investments.

Challenges to ESG integration
However, there are structural issues in the industry which still pose challenges to the wider development of ESG investing. Most notably, there remain concerns about “greenwashing”, where funds make unsubstantiated or misleading claims about the environmental benefits of a product, service, technology or company practice. 

According to a November 2019 report by SCM Direct, systemic issues include lack of rules or regulations on the calculation of ethical data, lack of proper audit procedures, and a variation of ethical scores between data providers. There have been calls for regulators to step in to prevent mis-selling of investment products, and for the process to be transparent so that investors can make fully-informed decisions that match their own ethical parameters correctly. 

The squeeze on credible sell-side research due to MiFID II research unbundling requirements, which has led to some brokers cutting research on small and mid-cap stocks, might also hinder the availability of sufficient information, leading to reduced liquidity and the level of investments going into companies lacking in quality analyst coverage. 

However, the industry has also stepped in to plug some key gaps. The sector of green and sustainability linked loans is a clear case in point, where the Asia-Pacific Loan Market Association has stepped in to address issues arising from the lack of standardisation across data formats and reporting. By working with other associations to publish the Green Loan Principles and the Sustainability Linked Loan Principles, clear signals have been sent to the industry to incentivise borrower’s achievement of ambitious and predetermined sustainability performance objectives. 

Another example is the Sustainability Accounting Standards Board in the United States, which establishes industry-specific disclosure standards across ESG topics that facilitate communication between companies and investors about financially material information. The Climate Disclosure Standards Board framework also provides a valuable framework for the related governance issues to manage climate-related risks. 

Conclusion
Given the concerns about overbanking, ESG presents a strong premise to offer clients interesting ideas and products aligned with their values, which have the potential of outperforming the market. Strong ESG performers with stakeholder-focused and adaptive-governance structures are also more likely to remain resilient in the changing world. As BlackRock’s Larry Fink has noted, “Disclosure should be a means to achieving a more sustainable and inclusive capitalism”. 

At the same time, managers who fail to integrate sustainability risks into investment decisions may find themselves at a competitive disadvantage, as ESG themes and best practices become the “new normal” of global markets.