ESG Issues in Investing PDF

1. Background: ESG Issues in Investing This chapter provides the context for this guide as well as shares information needed to understand the discussion on ESG issues in investing. 1.1. Context and Objectives of This Guide CFA Institute has been educating investment professionals on governance i...

1. Background: ESG Issues in Investing This chapter provides the context for this guide as well as shares information needed to understand the discussion on ESG issues in investing. 1.1. Context and Objectives of This Guide CFA Institute has been educating investment professionals on governance issues in investing for many years. In 2005, CFA Institute published “The Corporate Governance of Listed Companies: A Manual for Investors,” which was followed by a second edition in 2009. In 2008, with the growth in the body of knowledge on social and environmental issues, CFA Institute published “Environmental, Social, and Governance Factors at Listed Companies: A Manual for Investors.” The focus of the publication was how to integrate ESG risk and opportunity issues into a fundamental analysis of listed equities. Since then, CFA Institute has continued to produce educational content on ESG issues in investing in a variety of forms (e.g., short books, articles, conference proceedings, video, and audio). A number of CFA Institute members in different parts of the world who are on the cutting edge of the practice of considering ESG issues in investing have been keen to work with CFA Institute to produce more educational content in this area. There is also interest in knowing the perspective of members regarding ESG considerations in investments. Since 2013, CFA Institute has been pursuing its Future of Finance initiative,1 a global effort to shape a more trustworthy, forward-thinking financial industry that better serves society. These developments, together with a perceived need for a brief guide for investment professionals on the state of ESG considerations in investing, have led to the publication of this guide. As stated by Paul Smith, CFA, president and CEO of CFA Institute: CFA Institute believes that every investment analyst should be able to identify and properly evaluate investment risks, and ESG issues are a part of this evaluation, our exam curriculum emphasizes risk management, and our members are increasingly interested in continuing education materials on ESG. 1See www.cfainstitute.org/FutureFinance. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 3 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals In this context, the objectives of this guide are to (1) serve as a primer for investment professionals on ESG considerations in investments across asset classes, (2) inform the reader of the state of the discussion and practices regarding ESG considerations in investments, and (3) share the views of CFA Institute members regarding ESG considerations in investments. Throughout this publication, we refer to the results of a survey of CFA Institute members on ESG issues. On 26 May 2015, 44,131 members who are portfolio managers and research analysts were invited via email to participate in an online survey. The survey closed on 5 June 2015; 1,325 valid responses were received, for a response rate of 3% and a margin of error of ±2.7%. This guide was written in collaboration with practitioners who specialize in ESG issues. Some case studies included in this guide were contributed by these professionals and are duly sourced to them. 1.2. Examples of ESG Issues There is no one exhaustive list of ESG issues. ESG issues are often interlinked, and it can be challenging to classify an ESG issue as only an environmental, social, or governance issue, as Table 1 shows. These ESG issues can often be measured (e.g., what is the employee turnover for a company?), but it can be difficult to assign them a monetary value (e.g., what is the cost of employee turnover for a company?). Table 1. Examples of ESG Issues Environmental Issues Social Issues Governance Issues ■■Climate change and carbon emissions ■■Air and water pollution ■■Customer satisfaction ■■Board composition ■■Deforestation ■■Employee engagement ■■Biodiversity ■■Data protection and privacy ■■Gender and diversity ■■Energy efficiency ■■Community relations ■■Waste management ■■Water scarcity 4 WWW.CFAINSTITUTE.ORG ■■Human rights ■■Labor standards ■■Audit committee structure ■■Bribery and corruption ■■Executive compensation ■■Lobbying ■■Political contributions ■■Whistleblower schemes Background: ESG Issues in Investing 1.3. ESG Considerations Are Not New The consideration of ESG issues in investing for economic value is not a new phenomenon. Many investors have long considered such issues in fundamental investment analysis by including an assessment of reputational risk, regulatory developments, or such megatrends as an aging population. Some ESG analysis is also built into traditional analytical frameworks, such as Porter’s Five Forces. The modern references to ESG analysis, however, refer to a systematic consideration of relevant and material ESG issues rather than to a cursory inclusion of one or more of them. The consideration of ESG issues is a complement to (not a substitute for) traditional fundamental analysis, and ESG issues remain relevant throughout the investment process—from the initial analysis to the buy/ sell/hold decision to ongoing ownership practices. Because of the prominence of large corporations in the global economy and the large proportion of corporate securities held by fiduciary investors, as well as the challenge of trust in finance, 2 there is also a sustained interest in ESG issues in investing by civil society, policymakers, and, of course, news media. 1.4. Various Labels, Same Issues Various labels are used to describe investments that consider ESG issues, from the relatively traditional socially responsible investing to the more recent responsible investing and sustainable investing. Traditional socially responsible investing is most closely associated with avoiding morally questionable businesses, whereas sustainable investing is usually characterized by identifying investment risks and opportunities with the help of ESG analysis. There is, however, a lack of consistency in the use of such labels, and different labels can be used to mean overlapping ideas. Today, those who say they practice socially responsible investing describe it in much the same way as those who say they practice sustainable investing. The common theme underlying the various labels is an emphasis on ESG issues. Therefore, in this guide, we use the relatively neutral term ESG issues to remain focused on how these issues need to be considered for a more complete investment analysis and better-informed investment decisions regardless of how the investment may be labeled. 2See www.cfainstitute.org/learning/future/getinvolved/Pages/investor_trust_study.aspx. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 5 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 1.5. Moral Values vs. Economic Value Investors consider ESG issues for various reasons. Some may see them solely as economic risks and opportunities—a source of economic value. Others may see ESG issues not just as risks and opportunities but also as a matter of moral values. Those motivated by moral values may not wish to become complicit in actions they find objectionable or may actively attempt to make a positive impact on society or the environment. For instance, regardless of the economics of investing in the tobacco industry, an individual investor or a healthrelated charity may find investing in tobacco unacceptable because smoking is harmful to one’s health. But other investors may not share the same concerns. They may invest in the tobacco industry if they believe it is an economically attractive investment, and they may look at ESG issues simply to complement their traditional financial analysis. A fundamental point in the “value versus values” debate is that all investors pursue the same economic value (even if with different investment objectives and time horizons), but they inevitably have different moral values. The different exclusionary screens used in traditional socially responsible investing help explain the different values being implemented in investing. Both the values-based and the value-based ESG approaches co-exist in investment management. Values-based investing has also shown growth and evolution. For example, consider that in faith-based finance, the global Islamic finance industry is widely reported as one of the fastest-growing segments in finance. Similarly, there is much interest among both investors and policymakers in modern impact investing, which blends value and values. That said, value-based investing is clearly larger than values-based investing. 1.6. Short-Termism A major and recurring theme regarding ESG issues is that they do not fit well with shorttermism in investing—that is, the excessive focus of some corporate leaders, investors, and analysts on quarterly earnings and a lack of attention to long-term value creation. There are structural reasons and practices that cause short-termism in financial markets, most notably, financial incentives and culture. ESG issues do not fit well with short-termism because they tend to affect financial performance over longer periods. For instance, the poor governance of a large company is more likely to affect the company over the long term than in the next quarter. CFA Institute has been covering the issues of short-termism and corporate culture in its publications, and in the interest of brevity, we do not discuss those issues here.3 3To see our work on short-termism, see www.cfainstitute.org/ethics/topics/Pages/explore_short_termism. aspx. 6 WWW.CFAINSTITUTE.ORG Background: ESG Issues in Investing 1.7. Externalities Whose responsibility are the externalities linked to ESG issues, such as climate change? More specifically, can the burden of externalities be left to governments and regulators to bear alone? One view is that confronting climate change through government policy, such as the EU’s emissions-trading system, has yet to generate the desired results. Investors should not knowingly leave something to governments that governments have yet to deal with effectively and that will inevitably affect the lives of beneficiaries of the investments. Another view is that fiduciary investors cannot be expected to take responsibility for what is beyond their control, and it is unrealistic to bring externalities within the ambit of fiduciary responsibility. Perhaps a middle ground between these two views on externalities and investment management is the pursuit of “stewardship” along the lines of the UK Stewardship Code, with a “comply or explain” requirement, which “aims to enhance the quality of engagement between asset managers and companies to help improve long-term risk-adjusted returns to shareholders.” 4 Another case in point is the Code for Responsible Investing in South Africa, which “gives guidance on how the institutional investor should execute investment analysis and investment activities and exercise rights so as to promote sound governance.”5 An interesting case in this debate on externalities is the very large investment funds with global portfolios—“universal owners”—that are exposed to the risk that some investments in the portfolio may affect the returns of other investments. For example, some companies might benefit by externalizing environmental costs through pollution, which, in turn, affects other companies, thus affecting the returns of the universal owner’s portfolio. Externalities are an economic reason why universal owners should engage with investee companies and policymakers, but the wider debate on externalities and institutional investors is far from settled. 4See 5See www.frc.org.uk/Our-Work/Codes-Standards/Corporate-governance/UK-Stewardship-Code.aspx. www.iodsa.co.za/?page=CRISACode. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 7 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 1.8. Majority Consider ESG Issues The discourse on ESG issues is based on the premise that these issues, particularly the environmental and social issues, do not receive sufficient consideration in investment decision making. A number of reasons are offered to explain why this is the case. Three stand out: ■■ It is difficult to assign a monetary value to ESG issues and to integrate them into quantitative models. ■■ ESG-related disclosure by companies may be limited, unverified, and nonstandardized. ■■ ESG issues tend to influence financial performance in the long term whereas many investors, as suggested earlier, have relatively short-term horizons. Despite these challenges, consideration of ESG factors is becoming more common. Evidence points to a growing awareness of ESG issues in investing. In our survey, only 27% of respondents said that they do not consider ESG issues. Thus, 73% consider at least environmental, social, or governance issues, or combinations thereof, in investment decisions (Figure 1). Figure 1. ESG Issues Considered Which, if any, of the following ESG issues do you take into account in your investment analysis or decisions? 64% 50% 49% 27% Governance 8 Environmental WWW.CFAINSTITUTE.ORG Social I do not take ESG factors into consideration Background: ESG Issues in Investing 1.9. Awareness Has Been Growing A well-known indicator of the increasing awareness of ESG issues is the rapidly growing list of signatories to the United Nations–supported Principles for Responsible Investment (PRI), the principal framework for investors who wish to integrate the consideration of ESG issues into their investment decision making. According to PRI, the assets under management (AUM) of its signatories have grown from less than $6 trillion at PRI’s launch in 2006 to nearly $60 trillion as of April 2015 (Figure 2). Critics argue that such voluntary consideration of ESG issues results in a reclassification of AUM without a substantive change in how investment decisions are made. Their point is not without merit, and we discuss this criticism later in the guide. But the sheer size of these assets supports the view that many asset owners, investment firms, and professional service providers are giving important consideration to ESG issues in making their investment decisions. Figure 2. PRI Signatories and Assets under Management Assets (US$ trillions) Number 70 1,600 60 1,400 50 1,200 1,000 40 800 30 600 20 400 10 200 0 0 Apr/06 Apr/07 Apr/08 Apr/09 Apr/10 Apr/11 Apr/12 Apr/13 Apr/14 Apr/15 Assets under Management Number of Signatories © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 9 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 1.10. ESG Data Usage Rising Another indicator of the growing awareness and consideration of ESG issues is the availability and usage of ESG data and professional services. According to Bloomberg, the number of its customers using ESG data grew by 76% during 2013–2014 (Figure 3). There is a growing number of ESG data and research providers as well as rankings and ratings from both mainstream and specialized providers, such as Reuters, MSCI, and Sustainalystics. Morningstar, a well-known provider of investment research, has announced that it will start offering ESG scores for funds in 2015. Figure 3. Bloomberg ESG Data Unique Users, FY2009–FY2014 Number of Customers 20,000 17,010 15,000 9,669 10,000 7,779 4,704 5,000 5,747 2,415 0 09 10 WWW.CFAINSTITUTE.ORG 10 11 12 13 14 Background: ESG Issues in Investing 1.11. ESG Issues: To Consider or Not to Consider Responding to the question, “Why do you take ESG issues into consideration in your investment analysis/decisions?,” the highest proportion of survey respondents selected “to help manage investment risks.” This response is consistent with the literature on ESG issues, which tends to describe them primarily as risk factors. The fact that clients/investors demand it came in second, which makes intuitive sense. When asset owners demand that investment managers pay attention to ESG issues, managers must take notice. The asset owners could be motivated by value and/or values. Interestingly, “regulation requires it” was selected by only 7% of respondents, supporting the view that the consideration of ESG issues in investing is not led by regulation (see Table 2). We asked those who responded that they do not consider ESG issues to share their reasons why. The top two reasons were lack of demand from investors and the immateriality of ESG issues. Not surprisingly, when these respondents were asked what would make them consider ESG issues, the top two reasons were demand from clients/investors and the materiality of ESG issues with respect to financial performance (see Figure 4). We return to the critical issue of financial performance and ESG issues later in the guide. Table 2. Why Consider ESG Issues? Survey Response Respondents (%) To help manage investment risks 63 Clients/investors demand it 44 It’s my fiduciary duty 37 ESG performance is a proxy for management quality To help identify investment opportunities My firm derives reputational benefit Regulation requires it Other 38 37 30 7 5 © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 11 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals Figure 4. Reasons for Not Considering/Considering ESG Issues A. Why do you not take any ESG issues into consideration in your investment analysis/decisions? 47% Lack of demand from clients/investors 35% These issues are not material—no added value Lack of information/data 21% Insufficient knowledge of how to consider these issues 21% 15% Inability to integrate ESG info in my quantitative models Not relevant to my job 7% Market practices require me to focus on short-term performance 5% 17% Other B. What, if anything, would cause you to begin considering ESG issues in your investment analysis/decisions? 57% Demand from clients/investors 48% Proven link between ESG and financial performance 29% Regulatory/legal requirements to consider ESG issues 25% Better information on ESG risks/opportunities 22% Clarity that it doesn’t conflict with my fiduciary duty 20% Development of the internal capability on how to consider these issues Nothing Other 12 WWW.CFAINSTITUTE.ORG 8% 5% Background: ESG Issues in Investing 1.12. Focusing on the Relevant and the Material There are numerous ESG issues, and an investment analyst must narrow them down to a set of issues that are most relevant and material. This process requires reasoning and empirical work and will vary by sector. For example, utilities face greater exposure to environmental risks than do software providers, just as clothing manufacturers face supply chain challenges concerning labor standards that do not seem to affect the financial services industry. A company that incorporates ESG exposures into its long-term strategic planning and adequately communicates that fact to investors will provide a more complete picture of its prospective value. Complementing traditional financial analysis with a consideration of ESG issues faces the challenge of the changing relative importance of these issues over time. In spite of this challenge, some industry- and sector-specific ESG performance indicator standards have been developed by such entities as the European Federation of Financial Analysts Societies and the Sustainability Accounting Standards Board. 1.13. Climate Change and Other Environmental Issues According to the Intergovernmental Panel on Climate Change (2014), the continued emission of greenhouse gases is “increasing the likelihood of severe, pervasive and irreversible impacts for people and ecosystems” and risks posed by climate change would require “substantial and sustained reductions in greenhouse gas emissions.” The World Economic Forum’s “Global Risks 2015 Report” lists “failure of climate-change adaptation” as number 5 of the “top 10 risks in terms of impact” (World Economic Forum 2015, p. 3). The risks posed by climate change mean that carbon-intensive energy sources face more regulation and taxation. Future climate change regulations will likely touch many sectors, including those outside carbon-intensive industries—most prominently, insurance. Although climate change may be the most prominent environmental issue facing investors, it is clearly not the only one. In the CFA Institute survey, respondents rated environmental degradation and resource scarcity above climate change (see Figure 5). 1.14. Social Issues Affect More Than Reputation Social issues play an increasingly important role in the public’s perception of investments. News of a poor health and safety record or oppressive labor practices can damage a company’s reputation and thus its profitability. Similarly, social trends, such as a growing concern about obesity, are likely to affect the long-term prospects of such sectors as food. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 13 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals The effects of social issues, however, are not confined to reputation. A breakdown in a company’s relationship with labor or the communities it operates in can hurt its profitability. But the effects need not be permanent. Companies can change their practices and convince their stakeholders and investors that they have done so. A case in point is Nike: In the 1990s, Nike was associated with sweatshops in its supply chain in developing countries but took corrective measures to address the issue. 1.15. Governance Issues Widely Considered Governance issues tend to remain relevant and material across companies and sectors. Historically, among the ESG issues, corporate governance has been covered the most in business and finance curricula and in investment research and analysis. In our ESG survey, respondents also cited a governance issue—board accountability—first when asked which set of issues they consider. Nevertheless, social issues (e.g., human capital) and environmental issues (e.g., environmental degradation) also appear among the issues rated highest by respondents (see Figure 5). Figure 5. Relative Importance of ESG Issues Please rate the following ESG issues in terms of importance to your investment analysis/decisions on a scale of 1 to 5, where 1 is not important at all and 5 is very important. 78% Board accountability 14 Human capital 62% Executive compensation 61% Environmental degradation 54% Resource scarcity 52% Demographic trends 50% Supply chain 47% WWW.CFAINSTITUTE.ORG Board diversity 41% Climate change 40% Background: ESG Issues in Investing The top rating given by these investment professionals to board accountability, followed by a mix of social and environmental issues, differs from the impression generated by some of the ESG news flows, which often center on climate change. 1.16. Principles, Standards, and Advocacy A number of principles, standards, and conventions—and associated advocacy organizations—serve as a common reference point for investors considering ESG issues, including PRI (mentioned earlier), UN Global Compact, Equator Principles, OECD Guidelines for Multinational Enterprises, International Labor Organization Declaration on Fundamental Principles and Rights at Work, SA 8000 (auditable social certification standards for decent workplaces), and ISO 26000 (guidance on how businesses and organizations can operate in a socially responsible way). Some investors use these frameworks in applying ESG methods, such as exclusionary screening and active ownership. Others are likely to refer to them in ESG integration. There are also organizations in different parts of the world that are working to promote ESG considerations in investing. These include the Global Sustainable Investment Alliance (including USSIF and Eurosif), Global Reporting Initiative, Sustainability Accounting Standards Board, World Resources Institute, International Integrated Reporting Council, CDP (formerly, Carbon Disclosure Project), Accounting for Sustainability, Global Impact Investing Network (GIIN), and International Corporate Governance Network, among many others.6 1.17. Law and Regulation A range of laws and regulations pertaining to ESG issues are already in place—and more keep coming. A 2013 study by KPMG, the Centre for Corporate Governance in Africa, the Global Reporting Initiative, and UNEP states that there are 180 laws and regulatory standards in 45 countries pertaining to corporate sustainability reporting; of those, 72% are mandatory (p. 8). A prominent example is the codes of corporate governance used in different parts of the world. Other examples include the exclusion of controversial weapons (Belgium), a stewardship code for institutional investors (United Kingdom), and disclosure of CSR (corporate social responsibility) activities of listed companies (Malaysia). A recurring development, in various parts of the world, is a requirement that investors 6For more information about some of these organizations, see http://bit.ly/ESG-orgs. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 15 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals disclose to what extent they consider environmental and social issues in investment decisions and shareholder rights. 1.18. Relevance across Asset Classes Most of the discourse on ESG issues has been focused on listed equities, but the practice of considering ESG issues with respect to other asset classes, most notably fixed income, is growing. In fixed income, ESG issues are mostly about risk. ESG analysis in fixed income considers how such issues as carbon emissions, labor relations, and corruption might affect issuers’ creditworthiness. A useful reminder is the case of the mining company Lonmin. After violent labor conflicts in Marikana, South Africa, in 2012, the company was forced to issue a warning regarding the servicing of its debt. Thus, risk pertaining to social issues, which could easily be overlooked in a traditional financial analysis, could also prove costly for fixed-income investors. As in equities, governance in fixed income is the most analyzed of the ESG issues. For example, in an emerging-market high-yield corporate debt issue, fixed-income investors need to understand the full corporate structure and governance of the issuing entity and related entities before making any investment decision. In recent years, such organizations as PRI and INSEAD have put together some case studies on ESG considerations in other asset classes, including private equity, but more needs to be done to clarify how to consider ESG issues across asset classes. 16 WWW.CFAINSTITUTE.ORG