ESG Issues in Investing (PDF)

3. Debate: Issues regarding ESG Considerations In this third and final chapter, we cover a range of issues that come up in the debate on ESG considerations in investing. 3.1. Disclosure Remains a Challenge Investors can consider ESG issues in their investment decisions only if they have relevant...

3. Debate: Issues regarding ESG Considerations In this third and final chapter, we cover a range of issues that come up in the debate on ESG considerations in investing. 3.1. Disclosure Remains a Challenge Investors can consider ESG issues in their investment decisions only if they have relevant and timely information to do so. At present, mandatory corporate disclosure provides limited information on ESG-related risks and opportunities. The ESG-related disclosure may be released at a different time than the regular financial statements, making integration harder. It is worth noting, however, that disclosure and data have improved. Some initiatives— such as the Sustainable Stock Exchanges Initiative,16 which shows how exchanges can work together with investors, regulators, and companies to enhance corporate ESG transparency—are seeking to improve ESG disclosure. Similarly, availability of data is on the rise, even if better quality and greater quantity are needed. For instance, the number of large global companies that disclose their greenhouse gas emissions and water management and climate change strategies to CDP, an environmental nongovernmental organization, rose from 295 in 2004 to 5,003 in 2014. Our survey shows that for the majority of respondents, public information, third-party research, and company reports are the main sources of ESG information. As many as 61% of respondents agree that public companies should be required to report at least annually on a cohesive set of sustainability indicators in accordance with the most up-to-date reporting framework (Figure 7). The challenge with voluntary disclosure is that companies may disclose and exaggerate only what reflects well on them and downplay or not disclose what does not. This behavior could both limit ESG analysis and bias it in favor of disclosure rather than performance. A clear majority (69%) of these respondents agree that ESG disclosures by listed companies should be subject to some level of independent verification. Respondents were divided on whether ESG disclosures should be subject to limited verification or similar to an audit and whether ESG professional services firms or public accounting firms should carry out the independent verification (Figure 8). 16See 30 www.sseinitiative.org. WWW.CFAINSTITUTE.ORG Debate: Issues regarding ESG Considerations Figure 7. ESG Information Sources and Mandatory Reporting A. How do you get ESG information/data? 75% 66% 64% 50% 46% 4% Public information Third-party research Reports and statements from the company Direct engagement with company Regulatory filings Other B. Do you agree or disagree that public companies should be required to report at least annually on a cohesive set of sustainability indicators in accordance with the most up-to-date reporting framework? 61% 23% Agree Disagree 16% No opinion © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 31 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals Figure 8. Verification of ESG Disclosures and Its Cost A. Do you think it is important that ESG disclosures be subject to some level of independent verification of ESG disclosures? 69% Yes 15% 16% No No opinion B. Which best represents your view on how much should be spent to obtain independent verification? 26% 21% 18% 16% 10% 6% 3% As much as the cost of the audit of the financial statements 32 Less than half as much as the cost of the audit of the financial statements Less than a quarter of the cost of the audit of the financial statements WWW.CFAINSTITUTE.ORG Less than 10% of the cost of the audit of the financial statements Less than 5% of the cost of the audit of the financial statements Other Don’t know Debate: Issues regarding ESG Considerations Disclosure and independent verification come with a cost. Only 10% of respondents said that listed companies should spend on an ESG audit as much as they spend on an accounting audit. 3.2. Fiduciary Responsibility The law regarding fiduciary duty varies from country to country and is thus difficult to generalize. Two reports—“A Legal Framework for Integrating Environmental, Social, and Governance Issues into Institutional Investment,” also known as the Freshfields Report (2005),17 and the Fiduciary II Report (2009)18—found that considering ESG issues in pursuing economic value is permitted, if not required, by legal interpretations of fiduciary duty. However, there remains some ambivalence on the subject. For instance, in our member survey, when asked why they consider ESG issues, 37% of respondents indicated that they do so because it is their fiduciary duty. Among those who do not consider ESG issues, 22% suggested that they would consider ESG issues if they had clarity that doing so does not conflict with their fiduciary duty. Based on an analysis of eight countries, including both common law and civil law jurisdictions, in the context of ESG integration, the report “Fiduciary Duty in the 21st Century” contends that “failing to consider long-term investment value drivers, which include environmental, social and governance issues, in investment practice is a failure of fiduciary duty” (Sullivan, Martindale, Feller, and Bordon 2015, p. 9). The case for the consideration of ESG issues by fiduciary investors is strengthened when the law governing fiduciary duty facilitates it. For example, in South Africa, the updated Regulation 28 of Pension Funds Act 24/1956, effective 1 January 2012, explicitly includes references to ESG considerations: A fund has a fiduciary duty to act in the best interest of its members whose benefits depend on the responsible management of fund assets. . . . Prudent investing should give appropriate consideration to any factor which may materially affect the sustainable long-term performance of a fund’s assets, including factors of an environmental, social and governance character. The reasoning underlying fiduciary responsibility is inevitably linked to what effect ESG considerations have on the financial performance of investments. There is a lingering misperception that the principal ESG method is exclusionary screening, to be used by only values-motivated investors. 17See 18See www.unepfi.org/fileadmin/documents/freshfields_legal_resp_20051123.pdf. www.unepfi.org/fileadmin/documents/fiduciaryII.pdf. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 33 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 3.3. Financial Performance Financial performance is one area that has received substantial, if not the most, attention in research on ESG issues. The Sustainable Investment Research Initiative Library,19 a searchable database of academic studies, lists hundreds of research papers regarding ESG issues, many of which are on performance. In 2014, a report by the University of Oxford and Arabesque Partners analyzed about 200 studies to assess how sustainable corporate practices can affect investment returns. It concluded that “88% of the research shows that solid ESG practices result in better operational performance of firms and 80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices” (Clark, Feiner, and Viehs 2014). There are other such literature reviews and metastudies. The metastudy on ESG issues and performance by Mercer (2009)—“Shedding Light on Responsible Investment: Approaches, Returns and Impact”—reached similar conclusions. The key point is that, on the whole, the empirical evidence does not support the notion that ESG considerations necessarily adversely affect performance. In the case of ESG integration, this finding makes intuitive sense because, in principle, there should be no adverse impact on performance if it is simply about doing a more complete investment analysis. 3.4. Fossil Fuel Divestment and Stranded Assets Divestment campaigns have been part of the evolution of ESG considerations in investing. A prominent divestment campaign concerned South Africa’s apartheid regime in the 1980s. Such campaigns tend to make their impact by influencing the public discourse, which could result in stigmatization of the companies and sectors involved and, more importantly, changes in legislation affecting them. The latest divestment campaign pertains to fossil fuels in the context of climate change and touches on a range of sectors, from coal mining to steel. Many educational endowments face pressure from students and other stakeholders to divest from fossil fuel. Some endowments have announced decisions to divest, whereas others have announced decisions not to divest. A key point made by divestment campaigners is that one should not be able to profit from injustice. But investment firms’ divestment based on moral values raises concerns about fiduciary duty and financial performance. One area in which the debate on fossil fuel divestment becomes an economic consideration for fiduciary investors is stranded assets. There is a risk that some climate-sensitive assets, most notably fossil fuel reserves, could suffer from write-offs or downward revaluations, or 19See 34 www.calpers.ca.gov/page/investments/governance/sustainable-investing/siri-library. WWW.CFAINSTITUTE.ORG Debate: Issues regarding ESG Considerations conversion to liabilities largely because of regulation. If financial markets do not price the risks of stranded assets, investment performance could be affected. 3.5. Regional Differences There are perceived differences across (and within) regions on how willing and able investment firms are to address ESG issues in investing. The results of our survey seem to confirm such differences. Some of the responses most favorable to ESG issues tended to come from the Europe, Middle East, and Africa (EMEA) region and the Asia-Pacific region and the least favorable from North America. A relatively high proportion of survey respondents in the Asia-Pacific region consider ESG issues (78%), followed closely by members in the EMEA region (74%). Respondents in the Americas region are the least likely to use ESG information in their decision-making process, but even there, a solid majority (59%) do consider ESG issues. The proportions of respondents who do not take ESG issues into consideration (33%) and do not think ESG training is necessary (30%) are highest in North America. There is a perception that, on the whole, Western Europe is leading the ESG practice. These regional differences could obviously change over time, and the reasons behind these differences are not well understood. For instance, in developed markets with relatively strong regulation, investors could arguably be assuming that some of the ESG issues are being taken care of through regulation. 3.6. Innovations in Impact Investing: Green Bonds and Social Impact Bonds The green bonds market came into being in 2007 with the help of multilateral banks. Green bonds enable capital raising and investment for new and existing projects with environmental benefits—but they are a process rather than a product. That’s because the Green Bond Principles, 20 their chief framework, are a set of voluntary guidelines about process. Although this market segment has grown quickly, a key question facing green bonds concerns additionality—that is, whether green bonds finance projects that would not be funded otherwise. With estimated issues below $100 million a year in 2015, green bonds remain a small niche in the overall fixed-income market. Another innovation in impact investing is social impact bonds, the first of which was launched in 2010. A social impact bond is a contract between a special purpose vehicle and the government in which the government commits to pay for improved social outcomes, 20 See www.icmagroup.org/Regulatory-Policy-and-Market-Practice/green-bonds/green-bond-principles. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 35 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals such as reduced recidivism rates for prisoners. Social impact bonds give investors a chance to address social problems through investing. They strike a balance between giving money away altruistically and seeking a financial return solely for one’s own benefit—an economic return plus a social return. The market for social impact bonds is estimated to be much smaller than the market for green bonds. 3.7. ESG Issues and Passive Investing Although ESG issues have historically been associated with active investing, they are also relevant to passive investing or, more generally, rules-based investing. Investors can benefit from ESG considerations when they are integrated into the benchmark index. A number of such indexes are being offered. In addition, passive investors can use active ownership to manage their ESG risks. However, they need a policy and systems to ensure that different investment managers do not take opposing positions while exercising active ownership on behalf of the same asset owner. 3.8. Modern Applications: Smart Beta ESG methods are being used with such techniques as smart beta. In the context of equity indexes, smart beta generally refers to weighting schemes that do not use market capitalization. There have been attempts to apply smart beta together with ESG criteria. One way to construct a smart beta ESG index is to use an alternative weighting to stocks already selected for higher ESG ratings. One such low-volatility smart beta ESG index was launched in 2015,21 which measures the performance of the 50 least volatile from within a selection of sustainable stocks and excludes alcohol, tobacco, gambling, armaments and firearms, and adult entertainment. Another way to build it is to first filter stocks using such criteria as low volatility and then apply ESG criteria for the alternative weighting scheme. 3.9. Obstacles to Practical Implementation There is some criticism of how ESG issues are taken into consideration. Some of the criticism echoes the arguments that environmentalist and entrepreneur Paul Hawken made against socially responsible investing in 2004. Hawken said that “the cumulative investment portfolio of the combined SRI [socially responsible investing] mutual funds is 21“S&P Dow Jones Launches Smart Beta ESG Index,” Global Investor (30 March 2015): www. globalinvestormagazine.com/Article/3441004/S-P-Dow-Jones-launches-smart-beta-ESG-index.html. 36 WWW.CFAINSTITUTE.ORG Debate: Issues regarding ESG Considerations virtually no different than the combined portfolio of conventional mutual funds” (Hawken 2004, p. 16). The implication is that if every company can be deemed investable using one method or another, the credibility of “responsibility” suffers. There is no denying the inherent subjectivity of ESG consideration, just as there is no denying the inherent subjectivity of active investing in general. However, the degree of subjectivity regarding both process and outcome remains an ongoing challenge for ESG integration. Two analysts applying discounted cash flow analysis may reach very different valuations, but there is reasonable clarity on what process they follow, and there are longstanding textbooks that explain this process. The same is not true of ESG integration. If “responsible” portfolios include investments with contested ESG performance, the greater subjectivity exacerbates the concerns about credibility. The practice of considering ESG issues needs more clarity on how to apply ESG methods— most notably, ESG integration. Of course, it can be understandably difficult to use evidencebased cause-and-effect attribution for ESG methods. Demonstrating how values-based exclusionary screening leads to avoiding certain businesses is relatively straightforward, but demonstrating how value-based ESG integration leads to better-informed investment decisions is more complex. Without understating this difficulty, not attempting to document how ESG integration informs investment decisions will not help its cause. It is important not to exaggerate the benefits of ESG analysis. It faces some of the same limitations as traditional analysis and may not necessarily lead to investment insights. For example, BP scored high in some ESG ratings before the Deepwater Horizon catastrophe in 2010. Similarly, Volkswagen scored high in some ESG ratings before its emissions scandal came to light in 2015. Although more disclosure on ESG issues by companies remains a demand by some investors, it is not without debate. One issue is that, although some investors seem favorably disposed to demand more disclosure from listed companies, the disclosure practices of investment management firms and asset owners regarding ESG issues are not known to be much better. One argument suggests that for investors to make the case for greater disclosure more convincing, they need to demonstrate that they are willing to walk the talk themselves. There is an expectation among those interested in ESG issues that as more and more investors consider ESG issues, more pressure is placed on the companies they invest in to improve their ESG performance—which should both reduce risk for investors and make the world a better place. There is, however, an ongoing tension between authenticity © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 37 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals and mainstreaming. If an increasing proportion of global AUM claims to consider ESG issues without attributable difference in investment decision making or in the behavior of investee companies, it will not help build the credibility of ESG considerations. 3.10. The Challenge of ESG Education Those who might consider ESG issues in investing remain in need of more education and training. A little over half (53%) of respondents indicated that employees at their firm do not receive training on ESG issues (Figure 9). Of those who do, the most common ways are miscellaneous sources (e.g., conferences and publications) and learning by doing (Figure 10). A low level of training and formal education does not breed confidence in how rigorously ESG issues are being considered in investment analysis. Although the literature on ESG issues covers their effect on financial performance extensively, there remains a gap regarding how to consider ESG issues in practice. Perhaps expanding on the “how to” should now rank higher on the ESG research agenda. Figure 9. Employee Training on ESG Issues Do any employees at your firm receive training on how to consider ESG issues in investment analysis/decisions? 18% Not sure 53% No 38 WWW.CFAINSTITUTE.ORG 29% Yes Debate: Issues regarding ESG Considerations Figure 10. Modes of Training on ESG Issues A. How do employees at your firm receive training on how to consider ESG issues in investment analysis/decisions? 72% 58% 31% 13% Miscellaneous sources (research papers, books, conferences) Learning by doing; it’s an art Live, in-person structured training course 7% Online structured training Other B. If you would like employees at your firm to receive training in considering ESG issues, what would be your preferred mode? 30% 23% 20% 13% 12% 2% Miscellaneous Online Learning Live, in-person Other sources structured by doing; structured (research training it’s an art training course papers, books, conferences) None of these; I do not think training in considering ESG issues is necessary © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 39 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 3.11. ESG Education and CFA Institute CFA Institute believes that every investment analyst should know about the investment risks and opportunities posed by ESG issues. CFA Institute helps investment professionals better understand ESG issues in investing through its educational programs—most notably, the CFA® Program—and learning opportunities for continuing professional development (CPD). ESG Content in the CFA Program Curriculum Like any other topic, the ESG content in the CFA Program is determined by the practice analysis process, 22 whereby CFA Institute determines what should be included in the CFA Program through a survey of investment practitioners. Although the CFA Program curriculum changes from year to year, the 2015 curriculum has the following readings that directly address ESG issues/responsible investing: ■■ Level I: Volume 4—Corporate Finance and Portfolio Management, Corporate Finance, Study Session 11, Reading 40, The Corporate Governance of Listed Companies: A Manual for Investors (Note: The reading is devoted to corporate governance.) ■■ Level II: Volume 3—Corporate Finance, Reading 26, Corporate Governance (Note: The reading includes a section specific to ESG risks.) ■■ Level III: Volume 4—Fixed Income and Equity Portfolio Management, Reading 24, Equity Portfolio Management (Note: Socially responsible investing is explained at some length.) Given the increasing interest in ESG considerations in investing, the Education Advisory Committee of CFA Institute initiated a reassessment of the coverage of ESG issues in the Candidate Body of Knowledge, 23 with the goal of identifying the scope and practical implications of ESG investing appropriate for the CFA Program. In 2014, as part of this initiative, four practice analysis sessions were held in London, New York City, Amsterdam, and Hong Kong with ESG experts. The participants at these meetings had considerable expertise in ESG issues and were a rather diverse group in terms of designation (both CFA charterholders and noncharterholders), perspective (buy side, sell side, investor relations, industry associations, and vendors), and market sector (equity, fixed income, and 22See 23See 40 www.cfainstitute.org/programs/cfaprogram/courseofstudy/Pages/practice_analysis.aspx. www.cfainstitute.org/programs/cfaprogram/courseofstudy/Pages/cbok.aspx. WWW.CFAINSTITUTE.ORG Debate: Issues regarding ESG Considerations private equity). Having conducted these practice analysis sessions, we are in the process of updating the ESG-related content in the CFA Program, and we will continue to evaluate the volume and emphasis of ESG issues in the CFA Program curriculum. CFA Institute CPD ESG Content CFA Institute has been producing educational content on ESG issues in investing for many years, which is now too extensive to be listed here. We have also been covering some of the key topics that underlie ESG issues, such as short-termism and gender and diversity, without necessarily labeling them ESG content. The CPD methods consist of events, including online events, and a variety of print and digital publications, with both shorter and longer reads. In 2014, we added an online course, ESG-100,24 to our growing list of ESG-related offerings. The ESG-100 provides questions and answers in a self-quiz format, so you can gain and/or test your understanding of ESG issues in investing. To our knowledge, this course is the only free online course regarding ESG issues. To assist investment professionals in accessing our CPD ESG content, we provide a one-page list.25 3.12. Conclusion Both value-motivated and values-motivated investors consider ESG issues in investment decisions. The practice of considering ESG issues in investing has evolved significantly from its origins in exclusionary screening of listed equities on the basis of moral values. There are, however, some lingering myths about ESG considerations, and the results of our survey have debunked three, as shown in Table 3. Table 3. Myth vs. Reality Myth Reality Investment firms consider ESG issues primarily for reputational reasons. The top reason investment professionals consider ESG issues is to manage risks. ESG methods are confined to exclusionary screening. There are six major methods, of which ESG integration is used most widely by investment professionals. ESG issues are mostly about climate change. 24See 25See The top ESG issue investment professionals consider is board accountability. www.cfainstitute.org/learning/products/onlinelearning/Pages/103978.aspx. www.cfainstitute.org/learning/future/knowledge/pages/esg.aspx. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 41 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals Important challenges face the evolving practice of considering ESG issues in investing. An obvious and structural challenge, which is not unique to ESG considerations, is shorttermism in financial markets. But there are others. For instance, the case for “what” and “why” for ESG considerations has been made with sufficient clarity, but there is a need to clarify “how to” apply ESG methods—most notably, ESG integration—across asset classes. One objective of this guide is to explain the state of ESG discourse to investment professionals. Although a number of topics are part of the ESG discourse, for investment professionals a key idea in the discussion of ESG issues is that systematically considering ESG issues will likely lead to more complete analyses and better-informed investment decisions. If you are a member of CFA Institute and you would like to participate in our educational initiatives regarding ESG issues, we invite you to join the CFA Institute members LinkedIn subgroup on ESG issues in investing. To see the continuing professional development resources regarding ESG issues in investing provided by CFA Institute, which are available to both members and nonmembers, please visit http://bit.ly/ESG-learn. 42 WWW.CFAINSTITUTE.ORG