Responsible Investment Looking to the Next Future
Responsible investment has been through many changes of name and methodology in the past couple of decades, transforming from a niche area where highly principled investors refused to buy shares in tobacco or arms companies, to its current status as a mainstream aspect of investment strategy and analysis in all asset classes.
There is now a raft of terms for investors to wade through; although there is a great deal of overlap between these terms, each has a specific meaning.
The most commonly used terms include ethical investment, sustainable investment, responsible investment, green investment and impact investment.
Doing well by doing good
Ethical investment excludes “sin stocks” that profit from industries regarded - by that particular investor - as sinful. These usually include arms, tobacco and gambling, but as one might expect, different investors (often churches or other religiously affiliated groups) have different views on ethics. Sustainable and responsible investment (often referred to in combination as SRI) ignore morality, being based on the belief that investors wanting to take a longer term view need to look outside the usual financial reporting. Because financial markets tend to be relatively short-term in their focus, and financial reporting supports that, adding these other issues to the analysis can offer long-term investors an edge. These extra-financial issues usually fall under the categories Environmental, Social and Governance or ESG. This analysis can either be overlaid on the traditional investment process or fully integrated into it.
The next stage
Impact investment and green investment are more recent developments which are increasingly popular. Impact investors expect a financial return on their capital, but also want to be able to measure a positive social impact of their investment.
For example, micro-finance and micro-insurance are intended to improve the financial infrastructure of communities in the developing world, but are also expected to make a profit for shareholders. In some cases, investors are prepared to accept lower than market returns, in others, no such trade-off is expected.
Everyone is doing it
Investors are putting large amounts of money into funds marketed as specifically responsible investments. However, as the managers and owners of more than $700tr assets (around half of all institutional assets in the market) have now signed up to the UN-backed Principles for Responsible Investment, which effectively demands integration of ESG principles, fencing off “responsible investment” in this way no longer seems reasonable. Instead, investors are likely to demand their asset managers integrate these principles into all investment products.
There are several drivers behind this change. These include: increasing proof of materiality (it can be shown that ESG performance can provide predictors of stock performance); demand from investors for products that will improve the world they live in; and regulatory pressure, in particular around environmental issues.
Investors are pragmatic
There is an increasing body of evidence, both academic and industry-based, to show that corporate governance metrics, if combined the right way with financial markers, can be a catalyst for outperformance.
“Corporate governance is the area where we can draw a link with the impact on performance,” says Yannick Ouaknine, a senior ESG analyst in the Societe Generale Corporate and Investment Banking. “That is where we have the longest reliable data series.” He explains that Societe Generale CIB has built research product on that field with over 10 years live track record to demonstrate such link. Although the level of interest from clients in ESG analysis varies from “convinced” to “pragmatic, and waiting for more evidence”, Mr Ouaknine observes “saying it’s not relevant doesn’t happen very often any more”.
Data quality and availability remain the biggest challenge
A major challenge for would-be responsible investors is simply amassing the relevant data in a digestible format. Although companies do increasingly report on things like their water usage or their relationship with local communities, if this is not in a standardised format, it is technically very difficult to integrate it into a pure quantitative first-line investment analysis. Group such as GRI (formerly the Global Reporting Initiative) and CDP (formerly the Carbon Disclosure Project) have led efforts to create universal standards for reporting issues affecting sustainability, but there is still a great deal to be done, both in persuading companies to report and standardising that reporting.
The cornerstone is reliable and relevant information. Some companies provide quantity of information in their annual reports, but it is not at all relevant from an investor standpoint...
Senior ESG analyst
Listed equities and beyond
All of these efforts were initially focused on listed equities, where the materiality appears more intuitive, and the concept of applying company reporting to analysis is uncontested. After some time, however, investors began to ask whether ESG issues were relevant in other asset classes too.
In private equity, it is fairly straightforward to argue that responsible investment is sensible, because all the arguments applying to public equities apply here too. In addition, many of the measures indicated by responsible investment practice can pay back quite rapidly in terms of savings made (where energy efficiency is improved, for example) or risks avoided (where environmental regulation is anticipated).
With fixed income, materiality may appear harder to argue for, but one of the key benefits of ESG analysis is that it enables investors to understand the risk involved in their investments better. This is just as applicable to corporate bonds as to equities - if a company is likely to face major fines for breaches of environmental regulations, for example, its creditworthiness will take a hit.
What is the impact?
If the first stage in the evolution of responsible investment was to apply its principles to equity investment, and the second was to extend them to further asset classes, then the third stage is in monitoring the impact of the decision and engaging with the companies in question.
This investor engagement with issuers is likely to get a big boost in Europe in the next couple of years as the revised Shareholders’ Rights Directive comes into effect. This will give companies the right to identify their beneficial shareholders, a significant logistical challenge in countries where most shares are held through several intermediaries.
Who owns what?
Currently not all custodians can help issuers find out who precisely their shareholders are, as there is little reward for such an onerous task. With the implementation of the directive, however, the back office will have to set in place systems that simplify this process or at least make it practicable.
This offers a lot of challenges for the [securities services] industry as a whole, as there is a new service to provide. It will be about the electronic flows that can be developed.
Senior adviser at SGSS in strategy for markets infrastructure
It's all about regulation
Where old-school ethical investing was driven by investor demand, regulatory frameworks are increasingly important in the evolution of responsible investing.
As well as having to up their game in terms of investor relations, corporates are having to grapple with more and more environmental and social regulation. Industrial pollution is now much more tightly controlled, while laws such as the UK’s Modern Slavery Act (2015) affect the social arena.
A better world for pensioners?
Pension funds are among the biggest institutional investors, but they are also very much constrained by regulation. They are almost all governed by prudential regulation, requiring them to prioritise their goal of paying pensions while exercising due prudence.
Emmy Labovitch of the OECD recently issued a report* examining the constraints on pension funds globally with respect to integrating ESG issues. Her conclusion was that while no regulatory system precludes it, there is no explicit endorsement either.
“There is no legislation that says ‘you must not’, but there is nothing that says you must do it,” she says. Pension funds have an obligation to act prudently and in the best long-term interests of their members. Since it is possible to make the argument that ESG investing improves long-term with a view to the long term outcome is better for global economic growth prospects, it can be argued that ESG integration is the most prudent approach, making it entirely acceptable for pension investors.
On the other hand, because the data is not yet definitive on whether ESG integration leads inevitably to outperformance, it is equally possible to argue that waiting for the evidence to improve is prudent.
The OECD, in the report, took the view that ESG factors may have a material financial impact on portfolio returns and “in the worst case ESG integration doesn’t harm investment performance”, says Ms Labovitch.
However, she reiterated the point that there are still real operational and technical obstacles to implementing ESG integration, because of the lack of standardisation of data and analytical models. “Once you address that, it becomes much easier to regulate.”
*OECD (2017), Investment governance and the integration of environmental, social and governance factors