Environmental, Social, Governance (ESG) investing is not a temporary trend for fund managers, but a movement that is gaining momentum, and one that could have a significant impact on firms’ operations
The multiplicity of fund managers and institutional investors makes it problematic to coin an all-pervasive classification for ESG; the definition is fluid and constantly changing, and it is belief-driven.
Organisations may prioritise any one of the guiding principles of ESG in their allocations. An investor may avoid equities or bond instruments in a particular market because of poor labour standards or repeated human rights violations, while another may exclude a country due to its poor environmental track record or permissive governance standards.
Investors approach ESG in different ways. Some investors may invest in companies that show little awareness of, or interest in, ESG traits but hope to reform this through partnering with boards and senior management to effect change, whereas others demand that ESG be a pre-condition for making any investments. It is a concept which has no fixed or prescriptive parameters.
ESG will require fund managers, and their appointed service providers, to make changes to their back offices, namely through the development of new technologies and better data aggregation if they are to effectively monitor and report on ESG matters. ESG reporting has to be accurate like any other performance or risk disclosure. The direction of travel is such that misreporting ESG will lead to exacting conversations with investors and regulators.
Standard Chartered explores some of the factors that have prompted investors and fund managers to put ESG at the core of their businesses.
The institutions behind the ESG charge
The last few years have witnessed a number of high-profile corporate scandals where chronic failures around policies and procedures have been exposed. Such corporate breakdowns and behavioural shortcomings hurt investors, as they can lead to declines in share value, regulatory fines, and reputational damage.
Many institutional investors are judging corporates not just on their return on equity, but on non-financial criteria, which increasing numbers argue have a significant influence on company performance. Issues are varied, but can include boardroom diversity, commitment to meeting international climate change obligations, perceived gender equality policies, as well as the more traditional considerations surrounding the nature of a company’s activities, such as tobacco and armaments.
Substantive efforts are being made to force corporates to implement ESG strategies. The Financial Times reported Legal & General Investment Management (LGIM) wrote to 84 global companies across six sectors stating it would vote against their board chairmen if they did not make material efforts around climate change.
Several large institutions in the Scandinavian markets such as Norway’s GPFG fund –managed by Norges Bank have divested from tobacco, producers of nuclear armaments and fossil fuels, and it is expected others will follow. Some fund management groups, including Amundi, have created their own bespoke low-carbon indices which exclude heavily polluting industries, favouring greener securities. FTfm reported in May 2017 that an increasing number of pension funds globally are divesting from companies with a strong association with fossil fuels, on fears that government actions on climate change could bring about financial losses.
This is a broad trend that Standard Chartered is seeing across fund management and institutional investors globally.
The reasoning behind ESG
Investors buy equities to generate a return, and certain fundamental variables will impact – either positively or negatively – the value of those securities. It is becoming increasingly accepted that ESG policies act as a positive factor.
Hermes Investment Management said that exposure to securities with high ESG risk can hurt performance, adding that companies with poor governance had underperformed their peers by up to 30 basis points (bps) per month since 2009. However, it acknowledged it was premature to conclude whether there was a definitive correlation between corporate environmental and social responsibility and performance. 
A recent study – Is your non-financial performance revealing the true value of your business to investors? – (Ernst & Young) found 89% of respondents believed that a sharp focus on ESG contributed to the generation of sustainable returns.
Emphasis on ESG can ultimately enable corporates to spot long-term investment risks, and identify new opportunities. Such risks could be a consequence of the imposition of new regulations, which challenge an existing industry and its practices. This could lead to investors being exposed to stranded asset risk.
For example, if a pension fund invests in a shale gas company, and international legislation restricts the extraction of this commodity, that investor could be left with a stranded asset which cannot be developed and will probably be devalued.
For funds that adopt a conventional approach to investment choices, the ESG agenda can also be highly relevant. Tobacco companies have delivered good shareholder value recently, but investors need to be wary of further restrictions being placed on the product which could seriously impact the value of their investment, even including an outright ban. This may seem far-fetched but reports have said Russia is contemplating a life-long ban of tobacco sales to anyone born after 2014. If other countries pursue similar policies, tobacco in its conventional form could become a stranded asset.
Pension funds or sovereign wealth funds (SWFs) are increasingly positioning their portfolios away from certain sectors and this is driven by the long-term nature of their liabilities. Many of these organisations will have exposure to bonds maturing over a 100-year time horizon, so any long-term holdings need to be sustainable and take account of trends that could be in their infancy or even non-existent right now but may have a material impact on portfolios at a later stage. In this vein, FTfm reported that 10 major food businesses are being pressured by a coalition of large investors to combat the overuse of antibiotics in their supply chains due to concerns about the knock-on health threat to humans.
A failure by corporates to look beyond quarterly results is a risk that long-term investors are considering. Institutions want exposure to corporates that have durable strategies, and an ESG focus can help them achieve this.
Retail investor capital allocations are also increasingly dictated by ESG. The end-clients of institutions are reappraising their investment priorities, and looking beyond net returns. Research supports the view that younger, millennial investors take a more active position on ESG issues like poverty and climate change than older generations.
A study in 2016 by Schroders found millennials would disinvest more readily from an organisation with links to armaments trading or manufacturing, or an association with regimes with poor human rights records. Major institutions such as global fund managers have to take into account the views of these investors and apply it to their portfolio structuring and analysis.
ation with links to armaments trading or manufacturing, or an association with regimes with poor human rights records. Major institutions such as global fund managers have to take into account the views of these investors and apply it to their portfolio structuring and analysis.
This retail activism is increasingly driving fund managers towards a closer embrace of ESG. Analysis by the Forum for Sustainable and Responsible Investment found the value of assets, which incorporate some form of ESG criteria, had increased from $4.8 trillion in 2014 to $8.1 trillion in 2016. It is very probable ESG flows will keep growing as investors take a more conscientious approach to allocating their money.
Regulators and governments have taken a lead too, most notably following the Paris Climate Conference (COP21) which created a framework to combat climate change. The COP21 Agreement will oblige signatories to reduce global warming to less than two degrees celsius, and achieve zero net carbon emission by 2050. Mark Carney, Governor of the Bank of England, warned that investors with fossil fuel exposures face devastating losses if they do not take such issues seriously.
Reporting ESG: A challenge for the back office
ESG reporting – by corporates to institutions, and by institutions to their own investors – is mixed but it is improving, driven for the most part by larger players.
ESG-savvy institutional and retail investors expect their fund managers to supply ESG data, so they can reconcile whether their public equity holdings correspond with their basic principles. This presents challenges for managers and their service providers, mainly because ESG is undefined and different clients expect varying levels of granularity in terms of transparency. ESG disclosure can be complex as it covers social, environmental, or political goals, and creating a standardised template to encapsulate all of these is very hard.
In addition to the myriad investor interpretations of ESG, there are also major jurisdictional divergences in terms of dictating how it should be reported. Some countries – such as France – demand companies report climate data and carbon footprints, and it seems highly likely that others will follow.
The likelihood of these reports being harmonised, however, looks remote, even within single blocs like the EU, and this is likely to create compliance challenges for fund managers. Some reporting frameworks are voluntary or pushed by certain investor groups but not others. Reconciling the expectations of different entities across multiple geographies is something institutions will have to manage.
Firms repeatedly highlight that existing regulatory reporting requirements on their investments, counterparties and risk management systems are not consistent across countries and this presents operational problems. It is highly probable any climate change reporting templates will cause similar compliance difficulties.
The EY study found 27% of respondents expected the COP21 agenda to significantly ramp up the amount of disclosures made by companies about their climate practices and risk management. Signing up to the UN Global Compact or the UN Principles for Responsible Investment (UNPRI) will also add to reporting.
At present, there has been no single standardised template covering ESG created by a supranational body. However, the Financial Stability Board (FSB) did establish a Task Force on Climate-related Financial Disclosures (TCFD), which seeks to create a disclosure framework around climate-related financial risk.
ESG is a cause, behind which, regulators and investors are increasingly throwing their collective weight, and it is a topic fund managers need to pay attention to. A failure to understand ESG could lead to long-term investment risk and capital flight. As investors become increasingly motivated by ESG, incorporation of such ideology into investment strategies is likely to become the new normal for fund managers.
 Legal & General warns companies exposed to climate change. (2017, April 4). Retrieved from www.ft.com/content/05b5dc92-1884-11e7-9c35-0dd2cb31823a
 ESG investing. (2016, September 6). Hermes Investment Management. Available at www.hermes-investment.com/ukw/wp-content/uploads/sites/80/2016/09/ESG-investing.pdf
 SRI Basics. US SIF: The Forum for Sustainable and Responsible Investment. Retrieved from http://www.ussif.org/sribasics