ESG 2021 Chapter 1 PDF

CHAPTER 1 INTRODUCTION TO ESG INVESTING There was a time when environmental, social and What is ESG investing? 4 governance (ESG) issues were the niche concern of a select group of ethical or socially responsible investors....

CHAPTER 1 INTRODUCTION TO ESG INVESTING There was a time when environmental, social and What is ESG investing? 4 governance (ESG) issues were the niche concern of a select group of ethical or socially responsible investors. That time Types of responsible investment 6 is long gone. Why integrate ESG? 12 The consideration of ESG factors is becoming an integral part of investment management. Asset owners and Putting ESG into practice 31 investment managers are developing ways to incorporate Key initiatives 33 ESG criteria into investment analysis and decision-making processes. The emergence of responsible investment Key facts 40 proponents, such as the United Nations Principles for Responsible Investment (PRI), has encouraged a Self-assessment 42 fundamental change in investment practices whereby investors explicitly employ ESG factor analysis to enhance Further reading 48 returns and better manage risks. Societal and client pressure – and the growing evidence of the direct financial benefits of incorporating ESG analysis – has led integration to become more mainstream. This chapter provides an overview of the concept of ESG as well as the different types of responsible investment and their implications. It highlights the main benefits of integrating ESG factors and identifies ways in which ESG investing is implemented in practice. ESG investing sits within a broader context of sustainability; this chapter also highlights a number of key initiatives in the business and investment communities that seek to assist all parties to navigate the associated challenges. 3  Chapter 1 – Introduction to ESG Investing CHAPTER 1 CHAPTER 1 INTRODUCTION TO ESG INVESTING 1 WHAT IS ESG INVESTING? 1.1.1 Define ESG. 1.1.2 Define the following sustainability-based concepts in terms of their strengths and limitations: corporate social responsibility; triple bottom line (TBL) accounting. ESG investing is an approach to managing assets where investors explicitly incorporate environmental, social and governance (ESG) factors in their investment decisions with the long-term return of an investment portfolio in mind. In other words, ESG investing aims to correctly identify, evaluate and price social, environmental and economic risks and opportunities. Table 1.1: ESG FACTORS DEFINED ENVIRONMENTAL FACTORS SOCIAL FACTORS GOVERNANCE FACTORS Definition Factors pertaining to the natural Factors that affect the lives Factors that involve issues tied world. These include the use of, of humans. The category to countries and/or jurisdictions, and interaction with, renewable includes the management of or are common practice in an and non-renewable resources human capital, non-human industry; as well as the interest (e.g. water, minerals, ecosystems animals, local communities of broader stakeholder groups. and biodiversity). and clients. The definition and scope of ESG There is currently no universal standard for assigning E, S and G issues, and they may overlap with one another. The assignment of these issues depends on the specific properties of investors, businesses and their stakeholders. Stakeholders are members of groups without whose support an organisation would cease to exist,1 as well as communities impacted by companies and regulators. Examples of the definition and scope of ESG issues can be illustrated by the two widely-referenced organisations in Table 1.2 and Figure 1.1. Table 1.2: EXAMPLES OF ESG ISSUES ENVIRONMENTAL SOCIAL GOVERNANCE Climate change. Human rights. Bribery and corruption. Resource depletion. Modern slavery. Executive pay. Waste. Child labour. Board diversity and structure. Pollution. Working conditions. Trade association, lobbying and Deforestation. Employee relations. donations. Tax strategy. Source: PRI.2 4  Chapter 1 – Introduction to ESG Investing Figure 1.1: YOUR GUIDE TO ESG REPORTING CHAPTER 1 Source: FTSE Russell. 3 ESG investing also recognises that the generation of long-term sustainable returns is dependent on stable, well- functioning and well-governed social, environmental and economic systems. This is the so-called triple bottom line (TBL) coined by business writer John Elkington. However, since its inception, the concept of TBL evolved from a holistic approach to sustainability, and further into an accounting tool to narrowly manage trade-offs. Because of this, Elkington ‘recalled’ the term in a 2018 Harvard Business Review article.4 Ultimately, ESG investing recognises the dynamic inter-relationship between social, environmental and governance issues and investment. It acknowledges that: ▶ social and environmental as well as governance issues may impact the risk, volatility and long-term return of securities (as well as markets); and ▶ investments can have both a positive and negative impact on society and the environment. Corporate social responsibility The concept of ESG investing is closely related to the concept of investees’ corporate sustainability. Corporate sustainability is an approach aiming to create long-term stakeholder value through the implementation of a business strategy that focuses on the ethical, social, environmental, cultural and economic dimensions of doing business.5 Related to this, corporate social responsibility (CSR) is a broad business concept that describes a company’s commitment to conducting its business in an ethical way. Throughout the 20th century and until recently, many companies implemented CSR by contributing to society through philanthropy. While this may indeed have a positive impact on communities, modern understanding of CSR recognises that a principles- based behaviour approach can play a strategic role in a firm’s business model. This led to the theory of TBL. www.cfauk.org 5  Chapter 1 – Introduction to ESG Investing The TBL accounting theory expands the traditional accounting framework focused only on profit to include two other performance areas: the social and environmental impacts of a company. These three bottom lines are CHAPTER 1 often referred to as the three Ps: 1. people; 2. planet; and 3. profit. While the term and concept are useful to know, including for historical reasons, they have been replaced in the industry with a broader framework of sustainability that is not restricted to accounting. Effective management of the company’s sustainability can: ▶ reaffirm the company’s license to operate in the eyes of governments and civil society; ▶ increase efficiency; ▶ attend to increasing regulatory requirements; ▶ reduce the probability of fines; ▶ improve employee satisfaction and productivity; and ▶ drive innovation and introduce new product lines. ESG investing recognises these benefits and aims to consider them in the context of security/asset selection and portfolio construction. There are many organisations and institutions contributing to the further exploration of interactions between society, environment, governance and investment. This curriculum focuses on how professionals in the investment industry can better understand, assess and integrate ESG issues when conducting stock selection, portfolio construction and engaging with companies. 2. TYPES OF RESPONSIBLE INVESTMENT 1.1.3 Define different approaches to ESG investing, their characteristics and the role that ESG plays in each of them: responsible investment; socially responsible investment (SRI); sustainable investment; best-in- class investment; ethical/values-driven investment; thematic investment; impact investment; green investment; social investment; shareholder engagement. ESG investing is part of a group of approaches collectively referred to as responsible investment. While ESG investing is concerned with how ESG issues can impact the long-term return of assets and securities, other responsible investment approaches can also take into account non-financial value creation and reflects stakeholder values in an investment strategy. While there is no standard set of criteria for identifying responsible investment, the main investment approaches are presented in this section to demonstrate the wide spectrum of different types of responsible investment. Responsible investment is an umbrella term for the various ways in which investors can consider ESG within security selection and portfolio construction. As such, it may combine financial with non-financial outcomes and complements traditional financial analysis and portfolio construction techniques. All forms of responsible investment, except for engagement, are ultimately related to portfolio construction (in other words, which securities a fund holds). Engagement, both by equity owners and bond holders, concerns whether and how an investor tries to encourage and influence an issuer’s behaviour on ESG matters. There is no standard classification in the industry; the types of responsible investment overlap and evolve over time. Figure 1.2 illustrates some of the conceptual differences between these approaches and how they range from strictly ‘finance-only’ investment, with no consideration of ESG factors, to the other end of the spectrum, where 6  Chapter 1 – Introduction to ESG Investing the investor may be prepared to accept returns below market in exchange for the high positive impact the projects and companies in the portfolio deliver. As investors move towards the right-hand side of the spectrum, CHAPTER 1 they are increasingly interested in aligning their capital with ESG-related investment opportunities, in order to capture associated financial returns, and/or to have a positive impact by financing solutions to societal challenges. Figure 1.2 A SPECTRUM OF CAPITAL SUSTAINABLE CONVENTIONAL AND FINANCIAL PHILANTHROPY SOCIAL IMPACT INVESTING RESPONSIBLE INVESTING INVESTING Traditional Venture Impact Fully commercial Social investing ESG investing philanthropy philanthropy investment investment | | | | | | Enhance Investment Address Address Investment with long-term with a focus on societal societal an intent to have value by using social and/or Limited or no challenges challenges a measurable ESG factors Focus environmental regard for ESG through the with venture environmental to mitigate outcome and practices provision of investment and/or social risks and some expected grants approaches return identify growth financial return opportunities | | Use of ESG metrics and methodologies | Social return Financial Social return Return Social return Social return and adequate market return Financial market and sub-market expectation only focused financial market focused on return only financial return rate long-term value Social impact Social and financial Financial returns Source: Stylised adaptation from Organisation for Economic Co-operation and Development (OECD),6 based on earlier versions from various organisations. For illustrative purposes only. Responsible investment Responsible investment is a strategy and practice to incorporate ESG factors into investment decisions and active ownership.2 It is sometimes used as an umbrella term for some (or all) of the investment approaches mentioned in the following sub-sections. At a minimum, responsible investment consists of mitigating risky ESG practices in order to protect value. To this end, it considers both how ESG might influence the risk-adjusted return of an asset and the stability of an economy, as well as how investment in, and engagement with, assets and investees can impact society and the environment. Socially responsible investment Socially responsible investment (SRI) refers to approaches that apply social and environmental criteria in evaluating companies. Investors implementing SRI generally score companies using a chosen set of criteria, usually in conjunction with sector-specific weightings. A hurdle is established for qualification within the investment universe, based either on the full universe or sector-by-sector. This information serves as a first screen to create a list of SRI- qualified companies. www.cfauk.org 7  Chapter 1 – Introduction to ESG Investing SRI ranking can be used in combination with best-in-class investment, thematic funds, high-conviction funds or quantitative investment strategies. CHAPTER 1 Best-in-class investment Best-in-class investment involves selecting only the companies that overcome a defined ranking hurdle, established using ESG criteria within each sector or industry. ▶ Typically, companies are scored on a variety of factors that are weighted according to the sector. ▶ The portfolio is then assembled from the list of qualified companies. Bear in mind, though, that not all best-in-class funds are considered to be ‘responsible investments’. Due to its all-sector approach, best-in-class investment is commonly used in investment strategies that try to maintain certain characteristics of an index. In these cases, security selection seeks to maintain regional and sectorial diversification along with a similar profile to the parent market cap index while targeting companies with higher ESG rating. The tracking error for MSCI World SRI, which is designed to represent the performance of companies with high ESG rating and employs a best-in-class selection approach to target the top 25% companies in each sector, is only 1.79% (see Table 1.3). CHARACTERISTICS OF AN SRI INDEX UTILISING A BEST-IN-CLASS APPROACH (NOT TESTED, FOR Table 1.3:  ILLUSTRATION ONLY) SECTOR PARENT SRI INDEX REGION PARENT SRI INDEX ESG PARENT SRI INDEX (%) INDEX (%) RATING INDEX INDEX (%) (%) (%) (%) Information 18.1 19.6 USA 63.8 60.7 Leader 24 67 technology Financials 15.4 14.6 Japan 8.1 7.5 Average 65 33 Healthcare 12.9 13.4 UK 5.3 – Laggard 10 0 Industrials 11 11.1 Canada 3.4 3.8 Consumer 10.3 10.9 France 3.7 4.3 discretionary Consumer staples 8.3 10.0 Other 15.7 19.2 Communication 8.5 4.5 services Materials 4.2 4.9 Energy 4.5 4.4 Utilities 3.6 3.2 Real estate 3.3 3.6 Source: MSCI.7 Sustainable investment Sustainable investment refers to the selection of assets that contribute in some way to a sustainable economy, i.e. an asset that minimises natural and social resource depletion. ▶ It is a broad term, with a broad range of interpretations that may be used for the consideration of typical ESG issues. ▶ It may include best-in-class and/or ESG integration, which considers how ESG issues impact a security’s risk and return profile. 8  Chapter 1 – Introduction to ESG Investing ▶ It is further used to describe companies with positive impact or companies that will benefit from sustainable macro-trends. CHAPTER 1 The term ‘sustainable investment’ can also be employed to mean a strategy that screens out activities considered contrary to long-term environmental and social sustainability, such as coal mining or exploring for oil in the Arctic regions. Thematic investment Thematic investment refers to selecting companies that fall under a sustainability-related theme, such as clean-tech, sustainable agriculture, healthcare or climate change mitigation. Thematic funds pick companies within various sectors that are relevant to the theme. A smart city fund, for example, might invest in companies offering activities or products related to electric vehicles, public transportation, smart grid technology, renewable energy and/or green buildings. Bear in mind, though, that not all thematic funds are considered to be responsible investments or best-in-class. Becoming one not only depends on the theme of the fund, but also on the ESG characteristics of the investee companies. Green investment Green investment refers to allocating capital to assets that mitigate: ▶ climate change; ▶ biodiversity loss; ▶ resource inefficiency; and ▶ other environmental challenges. These can include: ▶ low-carbon power generation and vehicles; ▶ smart grids; ▶ energy effciency; ▶ pollution control; ▶ recycling; ▶ waste management and waste of energy; and ▶ other technologies and processes that contribute to solving particular environmental problems. Green investment can thus be considered a broad sub-category of thematic investing and/or impact investing. Green bonds, a type of fixed-income instrument that is specifically earmarked to raise money for climate and environmental projects, are commonly used in green investing. → Further details on green investing and green bonds can be found in Chapter 3. Social investment Social investment refers to allocating capital to assets that address social challenges. These can be products that address the bottom of the pyramid (BOP). BOP refers to the poorest two-thirds of the economic human pyramid, a group of more than four billion people living in poverty. More broadly, BOP refers to a market-based model of economic development that seeks to simultaneously alleviate poverty while providing growth and profits for businesses serving these communities. Examples include: ▶ micro-finance and micro-insurance; ▶ access to basic telecommunication; ▶ access to improved nutrition and healthcare; and ▶ access to (clean) energy. www.cfauk.org 9  Chapter 1 – Introduction to ESG Investing Social investing can also include social impact bonds, which are a mechanism to contract with the public sector. This sector pays for better social outcomes in certain services and passes on part of the savings CHAPTER 1 achieved to investors. Impact investment Impact investing refers to investments made with the specific intent of generating positive, measurable social and/or environmental impact alongside a financial return (which differentiates it from philanthropy). These are usually associated with direct investments, such as in private debt, private equity and real estate. However, in recent years, impact investing has increasingly mainstreamed into the public markets. Impact investments can be made in both emerging and developed markets. They provide capital to address the world’s most pressing challenges by investing in projects and companies that may, for example: ▶ offer access to basic services, including housing, healthcare and education; ▶ promote availability of low-carbon energy; ▶ support minority-owned businesses; and ▶ conserve natural resources. Measurement and tracking of the agreed-upon impact generally lies at the heart of the investment proposition. Impact investors have diverse financial return expectations. Some intentionally invest for below-market-rate returns in line with their strategic objectives. Others pursue market-competitive and market-beating returns, sometimes required by fiduciary responsibility. The Global Impact Investing Network (GIIN) estimated the size of the global impact investing market to be US$502 billion (£361bn); its 2019 annual survey indicated that 66% of investors in impact investing pursue competitive, market-rate returns.8 Ethical (or value-driven) and faith-based investment Ethical (also known as value-driven) and faith-based investment refers to investing in line with certain principles, often using negative screening to avoid investing in companies whose products and services are deemed morally objectionable by the investor or certain religions, international declarations, conventions and voluntary agreements. Typical exclusions include: ▶ tobacco; ▶ alcohol; ▶ pornography; ▶ weapons; ▶ nuclear power; and ▶ significant breach of agreements, such as the Universal Declaration of Human Rights or the International Labour Organization (ILO)’s Declaration on Fundamental Principles and Rights at Work. From religious individuals to large religious organisations, faith-based investors have a history of shareholder activism to improve the conduct of investee companies. Another popular strategy is portfolio building with a focus on screening out the negative; in other words, avoiding ‘sin stocks’ or other assets at odds with their beliefs. In the following sections, we cover a few examples of faith-based negative screening. Christian Investors wishing to put their money to work in a manner consistent with Christian values seek to avoid investing in firms that: ▶ facilitate abortion, contraceptives or embryonic stem-cell research; or ▶ are involved in the production and sales of weapons. 10  Chapter 1 – Introduction to ESG Investing They often favour firms that support human rights, environmental responsibility and fair employment practices via the support of labour unions. CHAPTER 1 Shariah Investors seeking to follow Islamic religious principles cannot: ▶ invest in firms that profit from alcohol, pornography or gambling; ▶ invest in companies that carry heavy debt loans (and therefore pay interest); ▶ own investments that pay interest; ▶ liaise with firms that earn a substantial part of their revenue from interest; and ▶ invest in pork-related businesses. Table 1.4: NEGATIVE SCREENING STRATEGIES NEGATIVE SCREENING CHRISTIAN FUNDS ISLAMIC FUNDS SRI FUNDS Alcohol ✓ ✓ ✓ Gambling ✓ ✓ ✓ Tobacco ✓ ✓ Pornography ✓ ✓ Pork products ✓ Interest-based financial services ✓ High leverage companies ✓ Anti-family entertainment ✓ Marriage lifestyle ✓ Abortion ✓ Human rights ✓ ✓ Workers' rights ✓ ✓ Bioethics ✓ Weapons ✓ ✓ ✓ Source: Adapted from Inspire Investing.9 Shareholder engagement Shareholder engagement reflects active ownership by investors in which the investor seeks to influence a corporation's decisions on matters of ESG, either through dialogue with corporate officers or votes at a shareholder assembly (in the case of equity). It is seen as complementary to the before-mentioned approaches to responsible investment as a way to encouraging companies to act more responsibly. Its efficacy usually depends on: ▶ the scale of ownership (of the individual investor or the collective initiative); ▶ the quality of the engagement dialogue and method used; and ▶ whether the company has been informed by the investor that divestment is a possible sanction. → For further details on the process of engagement, see Chapter 6. www.cfauk.org 11  Chapter 1 – Introduction to ESG Investing 3 WHY INTEGRATE ESG? CHAPTER 1 1.1.4 Describe the benefits to organisations of adhering to good practice in ESG, and the linkages between these practices and financial system stability: reduce costs and increase efficiency; reduce risk of fines; avoid costs from repercussions of investee’s externalities; and improve ability to benefit from sustainability megatrends. 1.1.5 Describe the challenges to organisations of adhering to good practice in ESG including: investment mandate interpretation and screening application; isolating the impact of ESG; strategy definition: risk management versus value creation/materiality; portfolio construction and management tools; disclosure of internal standards and practices; data quality, variability and interpretation; identifying material ESG factors. 1.1.6 Explain the materiality of ESG issues in terms of their key characteristics, risks and impact that they can cause. 1.1.7 Explain different ESG megatrends, their systemic nature and potential impact on companies and company practices. There is a range of beliefs about the purpose and value, both to investors and to society more broadly, of integrating ESG considerations into investment decisions. Some of the main reasons for integrating ESG are detailed in this section. It starts with an overview of some important perspectives in the debate on integrating ESG, financial materiality of integration and challenges in integrating ESG, and finishes with integration and financial performance. A. Macro-level debate on integrating ESG The following section describes various perspectives from which, over the years, the debate on the purpose and value of integrating ESG has been held. These include perspectives of risk, fiduciary duty, economics, impact and ethics, client demand and regulation. Risk perspective Figure 1.3: TOP GLOBAL RISKS From economic to environmental. Climate now tops the risks agenda, while the economy has disappeared from the top five. LIKELIHOOD IMPACT 2020 2020 2019 2019 2018 2018 2017 2017 2016 2016 2015 2015 2014 2014 2013 2013 2012 2012 2011 2011 2010 2010 2009 2009 2008 2008 2007 2007 Economic Environmental Geopolitical Societal Technological Source: World Economic Forum.10 12  Chapter 1 – Introduction to ESG Investing Evidence of the risks these megatrends carry is illustrated by the World Economic Forum’s 2020 Global Risk Report, which for many years now has highlighted the growing likelihood and impact of extreme CHAPTER 1 weather events and the failure to address climate change.10 Note that Figure 1.3 highlights how risks related to the environment have been significantly increasing in importance in the past years. Environmental risks are high on the radar. In 2015, Mark Carney, then Governor of the Bank of England and chairman of the Financial Stability Board, the international body set up by the G20 in 2009 to monitor risks to the financial system, referred to this challenge in a speech that became a cornerstone for the integration of climate change to financial regulators. “Climate change is the tragedy of the horizon. We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix… The horizon for monetary policy extends out to two to three years. For financial stability it is a bit longer, but typically only to the outer boundaries of the credit cycle – about a decade. In other words, once climate change becomes a defining issue for financial stability, it may already be too late.”11 In his annual letter to chief executives in 2020,12 Larry Fink, the CEO of BlackRock, stated that the investment firm would step up its consideration of climate change in its investment considerations because it was reshaping the world's financial system. Concretely, in a parallel letter to its clients BlackRock committed to divesting from companies that generate more than 25% of their revenues from coal production from its actively managed portfolios, and required reporting from investee companies on their climate-related risks and plans for operating under the goals of the Paris Agreement to limit global warming to less than 2°C (3.6°F).13 As the largest asset manager in the world, BlackRock’s decision could represent a new paradigm in the investment industry in which the integration of material ESG factors is mainstream. Prudent investors are engaging with companies to ask them to disclose not only what they are emitting today, but how they plan to achieve their transition to the net-zero world of the future. There is value in being able to spot winners and losers in a rapidly changing risk landscape. Investors that are attempting to take advantage of this usually operate over a longer timeframe than the usual quarterly or one-year time horizon, with the objective of understanding emerging risks and new demands so that they can convert these into above-market performance. Case studies Water depletion Companies are already experiencing risks in their manufacturing due to water depletion, which has been aggravated by acute impacts of climate change. Water has largely been considered a free raw material and therefore used inefficiently, but many companies are now experiencing the higher costs of using the resource, as well as suffering increasing frequency of extreme weather events. Pacific Gas and Electric Company (PG&E), a listed American utility, was driven to bankruptcy proceedings due to wildfire liabilities.14 The company's equipment led to more than 1,500 fires between 2014 and 2017. As low humidity and strong winds worsen due to climate change, the fire hazard increases. In 2018, a problem with PG&E equipment was deemed to have led to fires that killed at least 85 people, forced about 180,000 to evacuate from their homes and razed more than 18,800 structures. cont'd... www.cfauk.org 13  Chapter 1 – Introduction to ESG Investing Case studies CHAPTER 1... Coca-Cola Company faced a water shortage in India that forced it to shut down one of its plants in 2004. The company has since invested US$2bn (£1.4bn) to reduce water use and improve water quality in the communities in which it operates. SABMiller, a multinational brewing and beverage company, has also invested heavily in water conservation, including US$6m (£4.3bn) to improve equipment at a facility in Tanzania affected by deteriorating water quality. In extreme cases, assets can become stranded, in other words, obsolete due to regulatory, environmental or market constraints. In Peru, for example, social conflict related to disruptions to water supplies resulted in the indefinite suspension of US$21.5bn (£15.5bn) in mining projects since 2010. There are many ways in which ESG factors can impact a company’s bottom line. Nonetheless, identifying those issues which are genuinely material to a sector and company is one of the most active challenges within ESG investment. Each company is unique and faces its own challenges related to its culture, particular business model, supply chain structure, etc. So not only are there substantial differences between sectors, there are also differences between what is most material to individual companies within a single sector. → For further details on how to assess materiality and what tools are available, refer to Chapters 7 and 8. Fiduciary duty perspective For many years, fiduciary duty was considered a barrier to considering ESG within investments. In the modern investment system, financial institutions or individuals, known as fiduciaries, manage money or other assets on behalf of beneficiaries and investors. Fiduciary duties exist to ensure that those who manage other people’s money act in their beneficiaries' interests, rather than serving their own. Beneficiaries and investors rely on these fiduciaries to act in their best interests, which are typically defined exclusively in financial terms. Due to the misconception that ESG factors are not financially material, some investors have used the concept of fiduciary duty as a reason not to incorporate ESG issues. In 2005, the United Nations Environment Programme Finance Initiative (UNEP FI) commissioned the law firm Freshfields Bruckhaus Deringer to publish the report titled A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment (commonly referred to as the Freshfields report). The report argued that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.”15 Despite the conclusions of the report, many investors continue to point to their fiduciary duties and the need to deliver financial returns to their beneficiaries as reasons why they cannot do more in terms of responsible investment. However, increasing academic studies and work undertaken over the last decade by progressive investment associations, including the UNEP FI and Principles for Responsible Investment (PRI) on the topic have clarified that financially material ESG factors must be incorporated into investment decision-making. The 2005 UNEP FI report15 and the more recent report published by the PRI in 201916 both argue that failing to consider long-term investment value drivers – which include ESG issues – in investment practice is a failure of fiduciary duty. The 2019 PRI report concludes that modern fiduciary duties require investors to: ▶ Incorporate financially material ESG factors into their investment decision-making, consistent with the time frame of the obligation. ▶ Understand and incorporate into their decision making the sustainability preferences of beneficiaries or clients, regardless of whether these preferences are financially material. 14  Chapter 1 – Introduction to ESG Investing ▶ Be active owners, encouraging high standards of ESG performance in the companies or other entities in which they are invested. CHAPTER 1 ▶ Support the stability and resilience of the financial system. ▶ Disclose their investment approach in a clear and understandable manner, including how preferences are incorporated into the scheme’s investment approach. → For further details on fiduciary duty, see Chapter 2. Economics perspective Another reason for implementing ESG stems from the recognition that negative megatrends will, over time, create drag on economic prosperity as basic inputs (such as water, energy and land) become increasingly scarce and expensive, and the prevalence of health and income inequalities increase instability both within countries and between the ‘global north and south’. There is an understanding that, unless these trends are reversed, the economies will be weakened, exposed to sustainability-led bubbles and spikes. While this may not have a significant impact on asset managers whose performance is judged by their ability to provide alpha, it may considerably impact asset owners, who depend on total returns in the long-term to pay out pensions and their liabilities. The Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, has already identified climate change as a potential systemic risk. This may also be the case for other issues. The economic implications of these environmental issues (such as climate change, resource scarcity, biodiversity loss and deforestation) and social challenges (such as poverty, income inequality and human rights) are increasingly being recognised. In fact, the Stockholm Resilience Centre has identified nine ‘planetary boundaries’ within which humanity can continue to develop and thrive for generations to come,17 but in 2015 found that four – climate change, loss of biosphere integrity, land-system change and altered biogeochemical cycles (phosphorus and nitrogen) – have been crossed. Two of these – climate change and biosphere integrity – are deemed ‘core boundaries’, for which significant alteration would ‘drive the Earth System into a new state’. www.cfauk.org 15  Chapter 1 – Introduction to ESG Investing Figure 1.4: STOCKHOLM RESILIENCE CENTRE’S NINE PLANETARY BOUNDARIES CHAPTER 1 Source: J. Krantz/Azote based on Steffen et al (2015).18 A popular framework that builds on that of ‘planetary boundaries’ is the doughnut economics. Figure 1.5 shows this visual framework. It is a diagram developed by economist Kate Raworth that combines planetary boundaries with the complementary concept of social boundaries. The name comes from the shape of the diagram, a disc with a hole. 16  Chapter 1 – Introduction to ESG Investing Figure 1.5: DOUGHNUT ECONOMICS CHAPTER 1 Source: K. Raworth (2017).19 Social issues are also having a significant impact in the wider economy. Income inequality in OECD countries is at its highest level for 30 years, and Oxfam estimates that 26 of the richest billionaires own as many assets as the 3.8bn people who make up the poorest half of the planet’s population.20 This significant level of income inequality is creating a number of social stresses, including security-related issues.21 In 2014, the world spent 9.1% of its gross domestic product (GDP) on costs associated with violence. Undernutrition is also still common in developing economies and has severe economic consequences: the economic cost of undernutrition to Ethiopia alone is just under US$70m (£50m) a year. While the number of undernourished people in the world has declined sharply, there are still one-in-eight suffering from chronic malnutrition. Large institutional investors have holdings, which, due to their size, are highly diversified across all sectors, asset classes and regions. As a result, the portfolios of universal owners, as they are known, are sufficiently representative of global capital markets that they effectively hold a slice of the overall market. Their investment returns are thus dependent on the continuing good health of the overall economy. Inefficiently allocating capital to companies with high negative externalities can damage the profitability of other portfolio companies and the overall market return. It is in their interests to act to reduce the economic risk presented by sustainability challenges to improve their total, long-term financial performance. There is therefore a growing school of thought that investors should integrate the price of externalities into the investment process, and take into account the wider effects of investments by considering the impact on society and environment, and in the economy as a whole. www.cfauk.org 17  Chapter 1 – Introduction to ESG Investing For that reason, investors increasingly call for governments to set policies in line with the fundamental challenges to our future. The UN Sustainable Development Goals (SDGs),22 an agreed framework for all UN CHAPTER 1 member state governments to work towards in aligning with global priorities (such as the transition to a low- carbon economy and the elimination of human rights abuses in corporate supply chains), was welcomed by the investment community. → For further details on the SDGs, see Section 3 of this chapter. Impact and ethics perspective Yet another reason for practising responsible investment is some investors’ belief that investments can, or should, serve society alongside providing financial return. This translates into focusing on investments with a positive impact and/or avoiding those with a negative impact. ▶ Those investing for positive impact see investment as a means of tackling the world’s social and environmental problems through effective deployment of capital. The aim is to put beneficiaries’ money to good use rather than to invest it in any activity that could be construed as doing harm – essentially a moral argument. This idea is giving rise to the growing area of impact investment, itself a response to the limits of philanthropy and a recognition of the potential to align returns with positive impacts. ▶ Those avoiding negative impact, at times for religious reasons, usually do not invest (negative screening) from controversial sectors (such as arms, gambling, alcohol, tobacco and pornography). Client demand perspective Clients and pension fund beneficiaries (defined in more detail in Chapter 2) are increasingly calling for greater transparency about how and where their money is invested. This is driven by: ▶ growing awareness that ESG factors influence: » company value; » returns; and » reputation. ▶ increasing focus on the environmental and social impacts of the companies they are invested in. Asset owners (as defined in Chapter 2) are instrumental for responsible investment because they make the decisions about how their assets, representing on average around 34% of GDP in OECD countries, are managed.23 The number of them that are integrating ESG continues to grow. In 2019/20, 89 further asset owners signed up to the PRI with debut signings made in Columbia, Singapore, Portugal, mainland China and Uruguay. In 2020, a group of asset owners launched the Net-Zero Asset Owner Alliance under the auspices of the UN, committing to transition their investment portfolios to net-zero greenhouse gas (GHG) emissions by 2050. → Further details on the demand for, and supply of, responsible investment, as well as the market more broadly, are discussed in Chapter 2. Regulatory perspective Finally, regardless of their views or beliefs, some investors are being required to increasingly consider ESG matters. Since the mid-1990s, responsible investment regulation has increased significantly, with a particular surge in policy interventions since the 2008 financial crisis. Regulatory change has also been driven by a realisation among national and international regulators that the financial sector can play an important role in meeting global challenges, such as climate change, modern slavery and tax avoidance. Across the world’s 50 largest economies, the PRI found that 48 have some form of policy designed to help investors consider sustainability risks, opportunities or outcomes. In fact, across these economies, there have been over 730 hard and soft law policy revisions, which encourage or require investors to consider long-term 18  Chapter 1 – Introduction to ESG Investing value drivers, including ESG factors. Hard law are actual binding legal instruments and laws. Soft law are quasi- legal instruments which do not have legally binding force, or whose binding force is somewhat weaker than the CHAPTER 1 binding force of traditional law. Soft law over time may become hard law. → For further details on how regulation has played a key role in increased demand for responsible investment, refer to Chapter 2. Figure 1.6: CUMULATIVE NUMBER OF POLICY INTERVENTIONS PER YEAR 700 650 600 550 500 450 400 350 300 250 200 150 100 50 0 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 Source: PRI.24 B. Financial materiality of integrating ESG One of the main reasons for ESG integration is recognising that ESG investing can reduce risk and enhance returns, as it considers additional risks and injects new and forward-looking insights into the investment process. ESG integration may therefore lead to: 1. reduced cost and increased efficiency; 2. reduced risk of fines and state intervention; 3. reduced negative externalities; and 4. improved ability to benefit from sustainability megatrends. Each of these outcomes is described in the following in greater detail. 1. Efficiency and productivity Sustainable business practices build efficiencies by: ▶ conserving resources; ▶ reducing costs; and ▶ enhancing productivity. www.cfauk.org 19  Chapter 1 – Introduction to ESG Investing Sustainability was once perceived by businesses and investors as requiring sacrifices, but the perception today CHAPTER 1 is very different. Significant cost reductions can result from improving operational efficiency through better management of natural resources like water and energy, as well as from minimising waste. Research conducted by McKinsey found that resource efficiency can affect operating profits by as much as 60%, and that more broadly, resource efficiency of companies across various sectors is significantly correlated with the companies’ financial performance.25 A study analysing data from the global climate database provided by CDP (formerly Climate Disclosure Project) estimated that companies experience an average internal rate of return of 27% to 80% on their low-carbon investments.26 A strong ESG proposition can help companies attract and retain quality employees, and enhance employee motivation and productivity overall. Employee satisfaction is positively correlated with shareholder returns. The London Business School’s Alex Edmans found that the companies that made Fortune’s 100 Best Companies to Work For list generated 2.3% to 3.8% higher stock returns a year than their peers over a greater than 25-year horizon.27 Case studies Savings from efficiency measures Unilever Since 2008, Unilever avoided over €733 million (£639m) of energy costs, saved over €122m (£106m) by improving water efficiency across their factories, and saved around €223m (£106m) by using less material and producing less waste. It achieved these results via its eco-efficiency programme.28 The Dow Chemical Company Between 1994 and 2010, The Dow Chemical Company invested nearly US$2bn (£1.4bn) in improving resource efficiency, and saved US$9.8bn (£7bn) from reduced energy and wastewater consumption in manufacturing.29 The company’s long-established focus on resource efficiency cost reductions enabled it to achieve savings of US$31m (£22.3m) on its raw materials alone (compared to a net income of approximately US$4bn (£2.9bn)) in 2018. General Electric In 2013, General Electric reduced its GHG emissions by 32% and water use by 45% compared to the 2004 and 2006 baselines, respectively. This resulted in savings of US$300m (£215.7m).30 Aeon Group Between 2015 and 2018, the Japanese retail group Aeon achieved a decrease of 9.7% in food waste, which was equal to 32.14 kg / ¥1 million (£6,826) in net sales.31 Walmart Within ten years, Walmart improved the fuel efficiency of its fleet by approximately 87% through better routing, cargo loading and driver training. In 2014 alone, these improvements resulted in avoiding 15,000 metric tons of CO2 emissions and savings of nearly US$11m (£7.9m).29 Nike Almost half (40%) of Nike’s footwear manufacturing waste is generated by cutting scraps from materials such as textiles, leather, synthetic leather and foams. In 2018, modern cutting equipment, which can achieve smaller gaps between cut parts than traditional die-cutting can, were deployed to various factories. The estimated value of savings was US$12m (£8.6m) (compared to their net income of US$1.1bn (£0.8bn)) and nearly 1.2m kilograms of material for that fiscal year.32 20  Chapter 1 – Introduction to ESG Investing 2. Reduced risk of fines and state intervention CHAPTER 1 With all the discussion regarding climate change, dwindling energy resources and environmental impact, it is no surprise that state and federal government agencies are enacting regulations to protect the environment. Integrating sustainability into a business will position it to anticipate changing regulations in a timely manner. For example, a 2019 UN Environment Programme report found that there has been a 38-fold increase in environmental laws put in place since 1972.33 It also found that enforcement remains weak today but that significant events are indeed fined. It concluded that the level of enforcement could quickly change with little notice to investors. Analysis conducted by McKinsey calculated that, typically, one-third of corporate profits are at risk from state intervention (not only fines).25 For pharmaceuticals, the profits at stake are about 25 to 30%, and for the automotive, banking and technology sectors, where government subsidies (among other forms of intervention) are prevalent, the value at stake can reach 60%. Table 1.5: ESTIMATED SHARE OF EBITDA AT STAKE ESTIMATED SHARE OF EBITDA AT STAKE FOR EXAMPLE Capital requirements, systemic regulation ("too big to fail") Banks 50–60% and consumer protection Automotive, aerospace and defence, Government subsidies, renewable regulation and carbon- 50–60% technology emissions regulation Transport, logistics, infrastructure 45–55% Pricing regulation and liberalisation of sector Tariff regulation, interconnection, fibre deployment, spectrum Telecom and media 40–50% and data privacy Tariff regulation, renewables subsidies, interconnection and Energy and materials 35–45% access rights Resource nationalism, mineral taxes, land-access rights, Resources 30–40% community reach and reputation Obesity, sustainability, food safety, health and wellness, and Consumer goods 25–30% labelling Market access, regulation of generic drugs, pricing, innovation Pharmaceuticals and healthcare 25–30% funding and clinical trials Source: McKinsey Quarterly.25 www.cfauk.org 21  Chapter 1 – Introduction to ESG Investing Case studies CHAPTER 1 Major fines BP and Deepwater Horizon The biggest corporate fine to date was levied against BP in the wake of the 2010 Deepwater Horizon oil spill in the Gulf of Mexico, the largest in history. BP settled with the US Department of Justice for US$20.8bn (£15bn) in 2016;34 total compensation ultimately paid out by the company reportedly exceeded US$65bn (£46.7bn). Financial crisis and the Bank of America Several of the largest fines have hit the financial services industry, a direct result of the scrutiny facing banks in the wake of the financial crisis. These include the second highest, US$16.65bn (£12bn) fine paid by Bank of America in 201435 for its role in the subprime loan crisis. Just two years before that, the bank had agreed to a US$11.8bn (£8.5bn) settlement with the US federal government over foreclosure abuses. Volkswagen’s emissions scandal The third largest fine was paid by Volkswagen, which, in 2016, faced US$14.7bn (£11.5bn) in civil and criminal penalties from the USA in the wake of its scandal over emissions cheating.36 The scandal dampened the hype of diesel as a fuel for the future. Today, most major automotive companies are directing their current (and future) investments towards electric cars while striving to meet increasingly aggressive emissions targets. 3. Reduced negative externalities The term externalities refers to situations where the production or consumption of goods and services creates costs or benefits to others that are not reflected in the prices charged for them. In other words, externalities include the consumption, production and investment decisions of firms (and individuals) that affect people not directly involved in the transactions. Externalities can either be negative or positive. The concept of externality, though central to the concept of sustainability and responsible investment, dates back to 1920, having been introduced by Cambridge Professor Arthur Pigou in his book The Economics of Welfare. Externalities often occur when the production or consumption of a product or service's private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole. Example Pollution In the case of pollution, a polluter makes decisions based only on the direct cost and profit opportunity associated with production and does not consider the indirect costs to those harmed by the pollution. These indirect costs – which are not borne by the producer or user – may include decreased quality of life, higher healthcare costs and forgone production opportunities, for example when pollution harms activities, such as tourism. Professor William Nordhaus, who was recently awarded the Nobel Prize for his work on the externality of climate change, developed a model to measure the impact of environmental degradation on economic growth and thus, created a price for carbon pollution. However, externalities can also be due to social factors, for example when companies fail to pay a living wage or submit their employees to poor working conditions. 22  Chapter 1 – Introduction to ESG Investing In short, when externalities are negative, private costs are lower than societal costs, resulting in market CHAPTER 1 outcomes which may not be efficient or, in other words, leading to ‘market failures’. For that reason, externalities are among the main reasons why governments intervene in the economic sphere.37 Even back in the 1920s, British economist Arthur Pigou suggested that governments should tax polluters an amount equivalent to the cost of the harm incurred by others. Such a tax would yield the market outcome that would have prevailed with adequate internalisation of all costs by polluters. Internalisation refers to all measures (public or private) to ensure that externalities become reflected in the prices of commercial goods and services.38 As environmental and social regulation and taxation rise, it is expected that an increasing proportion of this cost might be forced into companies’ accounts. In the social sphere, recent developments in the interpretation of the OECD Guidelines for Multinational Enterprises39 and the UN Guiding Principles for Business and Human Rights40 – clarifying that these instruments apply to investors and give rise to responsibility for conducting human rights’ due diligence on investments – are in effect paving the way for more formal internalisation of social costs in hard law.41 Internalisation can happen in various ways. Taking the transportation industry by way of example, internalisation can happen through: ▶ market-based instruments, e.g. charges, taxes and tradable permits; ▶ regulatory instruments, e.g. vehicle emission and safety standards, traffic restrictions; or ▶ voluntary instruments, e.g. agreements with the car industry to reduce CO2 emissions from new passenger cars. Understanding the risks posed by ‘externalised’ environmental and social costs in the real economy is central to the practice of investment, as the internalisation of these externalities could significantly impact the costs and profits of companies’ products and services, affecting their bottom line. The uncertainty surrounding the timing and extent of internalisation is a critical component of the overall risk landscape facing investors. Beyond affecting companies’ financial performance, these externalities can also have a drag on the wider economy, potentially affecting the total return investors may achieve in the long term. A study by an environmental consulting company found that the top 3,000 publicly traded companies were responsible for US$2.15 trillion (£1.6tn) worth of environmental damage in 2008, and that global environmental damage was set to cost an estimated US$28tn (£20tn) by 2050.42 Environmental harm was found to be a material risk that could significantly affect the value of capital markets and global economic growth. Case studies Air travel and carbon emissions Before the COVID-19 pandemic, air travel was the source of around 2.5% of global CO2 and emissions, but it is estimated to grow by 300% by 2050. For that reason, the European Commission (EC) has been assessing and advocating for the internalisation of externalities associated with transportation for many years. In 2010, the European Union (EU) expanded the scope of its Emissions Trading System (ETS) to include aviation.43 The EU-ETS for aviation requires all non-commercial operators who travel into, out of and between EU and European Economic Area (EEA) Member States to monitor their CO2 flight emissions, and purchase carbon allowances equal to the emissions on intra-EU flights when emitting more than 1,000 tonnes of CO2 under the full scope (in, out and within the EU). In 2019, the Ministers of Finance of the Netherlands, Germany, France, Sweden, Italy, Belgium, Luxembourg, Denmark and Bulgaria asked the EC to introduce a measure to offset the CO2 emissions of planes. A report44 from the independent research and consultancy organisation CE Delft shows that tax exemptions for the aviation sector lead to: cont'd... www.cfauk.org 23  Chapter 1 – Introduction to ESG Investing Case studies CHAPTER 1... » higher passenger demand; » aviation sector growth (in terms of both jobs and value added); and » more flights. The report also shows that a tax could result in a 10% increase in average ticket price and an 11% decline in passenger demand, but on the other hand, CO2 emissions would decrease by 11%. Current Abolition of ticket tax Introducing VAT on all Introducing fuel situation tickets (19%) excise duty Impacts in the aviation sector Value Value Change Value Change Value Change Passenger demand (million) 691.5 718.5 +4% 570.4 −18% 616.0 −11% Average ticket price (€) 304 293 −4% 358 +17% 333 +10% Number of flights and +4% −18% −11% connectivity Employment (1,000 FTE) 362 376 +4% 296 −18% 321 −11% Value added (€ billion) 43.4 45.1 +4% 35.6 −18% 38.5 −11% CO2 emissions (Mton) 149.5 155.3 +4% 123.3 −18% 133.1 −11% People affected by noise (1,000) 2,851.5 2,919.8 +2% 2,495.9 −12% 2,637.1 −8% Aviation-related fiscal revenue 10.0 2.6 −74% 39.9 +297% 26.9 +168% (€ billion) Sweden and France have acted unilaterally:45 Sweden introduced a SEK60 to SEK400 (£5 to £34) carbon tax for all airline passengers in April 2018, while France introduced a levy of €1.50 (£1.31) to be charged on domestic and intra-European flights. In addition, France will charge €3 (£2.62) on flights outside the EU. A business class seat on a flight in the EU will include a €9 (£7.85) eco-charge from 2020, while a longer flight in business class will be €18 (£15.70) more expensive. The French government estimates that the ‘eco-tax’ will raise €180m (£151m) a year from flights which will be invested in other forms of transport like trains, according to the transport ministry. Air France has already said they expect the eco-tax to cost them an extra €60m (£52m) a year, which is believed to have encouraged them to buy more efficient planes in order to negotiate with the government.45 Price sensitivity for passengers is relatively low, however, and the tax is deemed more of a symbolic first step. It has been a practice employed in the past by governments to start environment-related taxes low and get people used to the idea before increasing them. For example, the UK’s landfill tax, introduced in 1996, started at £7 per tonne of waste deposited, but now stands at £91.35 per tonne, an effective deterrent.45 4. Improved ability to benefit from sustainability megatrends There is a multitude of implications from the so-called sustainability megatrends. Being able to integrate a response to these trends into business operations can be a success factor for an investee firm. From the investor perspective these megatrends can be part of a successful portfolio construction strategy. This is why business leaders, investors, economists and governments are increasingly recognising the economic implications of: 24  Chapter 1 – Introduction to ESG Investing ▶ social challenges (such as increasing income inequality, poverty, and human and labour rights abuses); and CHAPTER 1 ▶ environmental issues (such as climate change, biodiversity loss and resource scarcity). These factors have interacted with: ▶ the aftermath of the 2007-2008 financial crisis; ▶ ageing populations; ▶ the rise of emerging economies; and ▶ rapid technological changes. This interaction increases the complexity, and also the impact, that social and environmental challenges have on the growth and profitability of sectors and businesses. These is no agreement about what these megatrends are and how many of them exist. Four, which are widely recognised across governments and businesses, are put forward. Emerging markets and urbanisation The locus of economic activity and dynamism is shifting to emerging markets and to cities within those markets, which are going through industrial and urban revolutions simultaneously. While, until recently, 97% of the Fortune Global 500 were headquartered in developed economies, nearly half of the world’s large companies are expected to be headquartered in emerging markets by 2025. Nearly half of global GDP growth between 2010 and 2025 will come from 440 cities in emerging markets – 95% of them small and medium-size cities.46 That will impact not only where headquarters are, but also supply chains and their workforces, and the expectation of the local communities as well as where new consumers come from. Technological innovation Technology has always had the power to change behaviour and expectations. What is new is the speed of change. It took 76 years for the telephone to penetrate half of all US households. The smartphone has achieved the same in less than a decade.47 Accelerated adoption invites accelerated innovation. By 2014, seven years after the iPhone’s launch, the number of applications created had hit 1.2m, and users had downloaded more than 75bn total apps, more than ten for every person on the planet.46 Social media is the new social fabric, and acts as a platform for both crowd intelligence and influence. Its influence stretches far beyond its initial use as a means to stay connected with people, and reaches into corporate risk management and geopolitics. Both its capacity to mobilise online crowds as well as to lead people into narrow filter bubbles have had major repercussions in recent years, including civil strife. Furthermore, issues around human rights, including free speech, and tensions between big social media companies and sovereign nation states have led to headlines and point in the direction of a possible new ordering of societal power, the outcome of which remains to be seen. Artificial intelligence – namely computer systems able to perform tasks normally requiring human intelligence – is poised to change and grow at an exponential speed beyond the power of human intuition to anticipate. It is being used by the health industry to track patients’ data and medication intake, by businesses to automate customer service and robotise manufacturing, by energy companies’ smart grids to forecast energy supply and demand, and by self-driving cars to optimise routes. Gartner (an IT research firm) estimates that one-third of jobs will soon be replaced by smart machines and robots, and Google estimates robots will attain the level of the human intelligence by 2029. It has significantly impacted most sectors. Demographic changes and wealth inequality By 2030 the world’s population is projected to rise by more than 1bn. At the same time, the population is getting older. Germany’s population is expected to shrink by one-fifth, and the number of people of working age could fall from 54m in 2010 to 36m in 2060. China’s labour force peaked in 2012. Today, about 60% of the world’s population lives in countries with fertility rates below the replacement rate.46 www.cfauk.org 25  Chapter 1 – Introduction to ESG Investing A smaller workforce will place a greater onus on productivity for driving growth and may cause economists to rethink the economy’s potential. Caring for large numbers of elderly people has already started to reshape CHAPTER 1 industries and put severe pressure on government finances. At the same time, the rise in population overall will only increase the demand and stress on renewable and non-renewable resources. A growing global population is expected to demand 35% more food by 2030. Finally, increasing concentration of wealth and rising inequality have already led to increasing social strains. This increase in inequality happens across, and within, countries, contributing to depressed economic growth, criminal behaviour and undermined educational opportunities.48 Climate change and resource scarcity As the world becomes more populous, urbanised and prosperous, the demand for energy, food and water will rise. But the Earth has a finite amount of natural resources to satisfy this demand. Without significant global action, average temperatures are predicted to increase by more than 1.5°C (2.7°F), a threshold at which scientists believe significant and potentially irreversible environmental changes will occur. The interconnectivity between trends in climate change and resource scarcity is amplifying the impact: climate change could reduce agricultural productivity by up to a third across large parts of Africa over the next 60 years. Globally, demand for water will increase by 40% and for energy by 50%. In short, the world’s current economic model is pushing beyond the limits of the planet’s ability to cope. C. Challenges in integrating ESG ESG investing has seen rapid development in recent years but challenges still remain to its further growth. Challenges to taking a more proactive approach to ESG investing exist across the whole of the investment decision process. Prior to wishing to implement ESG: ▶ The perception that implementing ESG may have a negative impact on investment performance. ▶ The interpretation that fiduciary duty prevents investors from integrating ESG. ▶ The advice given by investment consultants and retail financial advisers, has many times not been supportive of products which integrate ESG. Once the decision has been made to implement ESG: ▶ The lack of understanding of how to build an investment mandate that effectively promotes ESG or lack of understanding of what are the needs of asset owners regarding ESG. ▶ The impression that significant resources, which may be lacking in the market or may be expensive, are needed. These include human resources, technical capability, data and tools. ▶ The gap between marketing, commitment and delivery of funds regarding their ESG performance. Some investors still question whether considering ESG issues can add value to investment decision-making despite wide dissemination of research that demonstrates that ESG integration can help limit volatility and enhance returns. Interviews conducted by the PRI note that investment professionals place a greater weight on experience from their own careers than they do on third-party evidence.49 It can thus be helpful for an internal evidence base to be built, or to engage with direct peers on ESG processes and investment benefits. Interpretations of fiduciary duty are partially related to perception of the impact on ESG investing on risk- adjusted returns. Despite regulators in various jurisdictions clarifying a modern interpretation of fiduciary duty, contrasting views remain as to how ESG integration fits with institutional investors’ duties. Some institutional investors remain reluctant to adapt their governance processes because they see a conflict between their responsibility to protect the financial interests of their beneficiaries and the consideration of ESG factors. The challenge is not only regarding the impact of ESG investing in portfolio returns. Screening, divestment and thematic investment strategies involve ‘tilting’ the portfolio towards desired ESG characteristics by over- or underweighting sectors or companies that either perform well or poorly in those areas. Institutional investors 26  Chapter 1 – Introduction to ESG Investing may feel that this conflicts with their obligation to invest prudently, as it involves straying from established market benchmarks. This increases the tracking error, a key measure of active risk widely used by the industry CHAPTER 1 that is due to active management decisions versus the benchmark made by the portfolio manager. An example is shown in Figure 1.7, which illustrates the sector breakdown of MSCI All Country World Index (MSCI ACWI), a common benchmark for global equity funds, by market capitalisation and carbon emissions. The utilities, materials and energy sectors account for less than 15% of portfolio weight, but over 80% of the overall carbon footprint. One might think that reducing the emissions of the portfolio necessarily results in the reduction of the portfolio’s exposure to these sectors. Addressing concern for tracking error might require some level of reassessment and redefinition of ‘active risk’, which may imply changes to, or new interpretations of, the existing principles in the investment industry. But, as Figure 1.7 shows, it is also possible to maintain a low tracking error (MSCI ACWI Low Carbon targets a tracking error of 30 basis points). The MSCI ACWI Low Carbon Target reduces annual carbon emissions of the portfolio by approximately 75% by overweighting companies with low carbon emissions (relative to sales) and those with low potential carbon emissions (per dollar of market capitalisation).50 Note that this analysis is conducted only with carbon emissions, which is a rudimentary proxy for a fund’s resilience to climate risk, as well as a fund’s contribution to a low-carbon economy. Nonetheless, the concept shows that ESG characteristics of a portfolio can be significantly different, while maintaining a limited tracking error. → For further details on the challenges of portfolio construction, refer to Chapter 8. Figure 1.7: MARKET CAP VS CARBON EMISSIONS 100% 3.6% 4.8% 3.3% 90% 3.7% 2.0% 19.1% 4.4% 3.7% 40.9% 80% 70% 20.4% 60% 50% 26.8% 25.9% 40% 30% 17.2% 20% 10% 0% MSCI ACWI MSCI ACWI MSCI ACWI MSCI ACWI low carbon target low carbon target Market cap weight Contribution to carbon emissions Information technology Financials Materials Utilities Energy Other Healthcare Consumer discretionary Industrial Communication services Consumer staples Materials Energy Utilities Real estate Source: MSCI.51 www.cfauk.org 27  Chapter 1 – Introduction to ESG Investing The barriers mentioned earlier, together with other reasons, may explain why investment consultants and retail financial advisers have offered advice that is not seen as supportive of ESG investing. Consultants and advisers CHAPTER 1 often base their advice on a very narrow interpretation of investment objectives. What they perceive as a lack of interest by asset owners in responsible investment has also contributed to them being less willing to integrate ESG investing into their mainstream offerings. Asset owners and individual retail investors can ensure ESG factors are standing items in meetings and ask how consultants and advisers integrate ESG factors into their advice. Investor-led initiatives can also increase engagement with these actors to enhance their understanding of ESG investing and together address barriers to its consideration in investment advice. Even once an investor has decided to consider ESG within investment decision-making, various barriers remain. Some asset owners feel that they do not have the scale or capacity to influence the products offered by fund managers. Others are unsure of how to integrate ESG within requests for proposals or mandates. The absence of clear signals from asset owners that they are interested in ESG investing means that investment managers ha