ESG Investing For Dummies: Defining and Measuring ESG Performance (2021)

IN THIS CHAPTER »» Surveying socially responsible investing »» Investigating impact investing »» Checking out faith-based investing Chapter 7 Approaches to ESG Investing I n Part 1 of this book, you get a good understanding of why investing in ESG is an important consideration for your portfolio. This part of the book focuses on the approaches to ESG investing that different investors may employ, and the types of instruments that they use to implement their strategy. This chapter, in particular, emphasizes that many terms have been used interchangeably to describe the incorporation of ethical, environmental, and social factors into investment fund management, such as ethical investment, green investment, and socially responsible investment. The definitions of these various terms all overlap, and many have particular significance for different industry participants. With the growth in investing in recent years, these industry terms have proliferated. However, distinct differences exist that influence how client portfolios should be structured as well as which investments meet social or environmental impact goals. CHAPTER 7 Approaches to ESG Investing 119 Understanding Socially Responsible Investing As outlined in Chapter 1, the integration of ESG factors is used to augment traditional financial analysis by recognizing potential risks and opportunities beyond technical valuations. While there is an overlay of social awareness, the main purpose of ESG valuation remains financial performance. Socially responsible investing (SRI) — the subject of this section — moves a step further than ESG by actively removing or choosing investments that correspond to particular ethical guidelines. The underlying motivation could be personal values, political ideology, or religious beliefs. Unlike ESG analysis, which influences valuations, SRI uses ESG factors to direct negative or positive screens on the investment universe. The definitions for SRI given by industry representatives include the following: »» The UK Social Investment Forum (SIF) defines SRI as an “investment which combines investors’ financial objectives with their commitment to social justice, economic development, peace or a healthy environment.” »» Eurosif defines SRI as an investment that “combines investors’ financial objectives with their concerns about social, environmental and ethical (SEE) issues.” Looking at reasons for SRI Regardless of the various definitions, there appear to be three common motives for SRI: »» To avoid investor participation in activities that they object to »» To inspire companies to improve their impact on society, the environment, or the economy »» To generate investment outperformance The first of these motives has historically provided the inspiration for SRI, but more recently, the other two factors have become increasingly important and are now the primary motivation for many SRI investors. Nevertheless, different SRI strategies are selected to respond to different investor motives, and each strategy could deliver a different result depending on the focus outcome, but traces of each motive are generally found in every strategy. 120 PART 2 Investing in ESG through Different Instruments Therefore, the key consideration is to view SRI as a long-term investment approach that integrates good ESG practices into the research, analysis, and selection process of securities within your investment portfolio. It combines fundamental analysis and engagement with an evaluation of ESG factors to identify companies with sustainable business goals (positive screening), while avoiding those with questionable practices (negative screening), in order to better capture long-term returns while benefiting society. Consequently, SRI promotes corporate practices other than profit maximization through capital investment. SRI strategies tend to follow the political and social dynamics of the time. This is an important factor for investors to recognize, because if a strategy is focused on a particular environmental, ethical, or social value, the investment may suffer if that particular value isn’t considered as relevant among investors in the future. Moreover, given that interest has grown in socially conscious investing, numerous funds and pooled investment vehicles are available to investors, including mutual funds and exchange-traded funds (ETFs), allowing exposure to multiple companies across many sectors with a single investment. However, investors need to read carefully through fund prospectuses to establish the precise philosophies that are employed by the fund managers, in order to ensure that they meet their own intended goals. It’s important to emphasize that there is a difference between SRI — which involves actively excluding or choosing investments based on explicit ethical guidelines — and impact investing, which looks to help an organization to complete a project or develop a program or do something positive to benefit society. (I cover impact investing later in the section “Evaluating Impact Investing.”) The main factors motivating SRI are primarily linked to investors’ desire to, for example, address climate change, the use of renewable energy, and water management, along with other environmental and social issues. Meanwhile, where exclusion screening persists — it’s still the most prominent strategy in terms of assets under management in Europe — tobacco is seen as the most popular exclusion criteria. Comparing a best-in-class strategy to an exclusion strategy One way to determine which companies may have the greatest positive impact is to adopt a best-in-class (BIC) strategy, which allows investors to choose those companies that have the best ESG scores in a particular industry sector. This also allows investors to choose a given criterion or target, and the final rating realized can be connected to the weighting of the criterion, which can depend on the sector. A BIC portfolio usually incorporates companies that meet both SRI/ESG and CHAPTER 7 Approaches to ESG Investing 121 conventional financial evaluations. However, some BIC portfolios don’t differ meaningfully from non-SRI portfolios, and so investors are increasingly searching for benchmarks or indexes that can be applied to implement a BIC approach. In short, getting best relative performance in terms of ESG scores doesn’t guarantee positive impact. The oldest SRI strategy is the exclusion strategy, which traditionally focused on the avoidance of “sin stocks,” such as companies concerned with the production or sale of alcohol, pornography, tobacco, and weapons. This approach systematically excludes companies, sectors, or countries from the acceptable investment universe when they are involved in activities that are considered questionable or unethical. This strategy can be applied at an individual fund or mandate level, but progressively even more so at an asset manager or owner level, across the entire product range of assets. However, some investors believe that for an exclusion strategy to be meaningful, it could be applied together with some attempt at engagement and stewardship policies, which implies that investors should hold symbolic amounts of stock in exclusion companies to be able to exercise voting rights. This allows active investors to show their commitment to creating a positive impact and better sustainability in portfolio companies. If they just sell the stock, the company may simply continue to operate in an unsustainable way that goes unchecked, which isn’t positive; however, they have to weigh any reputational risks that may be associated with continuing as an investor. Therefore, divestment may still be the best route with certain companies. Weighing the potential return on SRI decisions Some investors presume that integrating ESG factors into an SRI process will lead to lower returns, but there are growing indications that SRI could lead to greater returns. The principle is clear: The corporations that are most likely to operate effectively in the future are those with convincing social responsibility profiles, that trade in an objective and progressive way, with an executive team that tackles short-term risks while ensuring that the business is positioned to adjust to longterm transformational changes. Conversely, you shouldn’t expect that the returns from SRI indexes will be constant in the short term. There are likely to be short-term divergences in performance relative to the point in the economic cycle or market conditions. For example, SRI emerging market indexes have a fundamentally lower allocation to China than their non-SRI equivalents. This could cause return on investment (ROI) to diverge between these two indexes or portfolios if the Chinese equity market experiences strong gains or losses. 122 PART 2 Investing in ESG through Different Instruments In addition, there are concerns about the potential lack of diversity offered by ESG shares, given that many companies that meet the SRI criteria are predominantly large-cap stocks, which can limit the potential for diversification within investor portfolios. This could entail that investors find fewer opportunities within smallcap, mid-cap, and emerging market domiciled companies, while potentially excluding entire sectors, which enhances the risk of concentration within given sectors. The counterargument to this is that ESG incorporation into the SRI process allows investors to screen out companies engaged in unsustainable practices; this will exclude companies expected to underperform their competitors and result in a smaller but higher-quality investment universe. This suggests that any loss of portfolio efficiency will be more than offset by the more appealing investment characteristics of the remaining companies. Moreover, there are concerns over the ROI repercussions of limiting the universe of asset managers by excluding those that don’t observe a predetermined threshold of ESG integration. Many smaller asset managers have the ability to generate persistent alpha (in other words, consistently finding excess return in their portfolio) but haven’t fully incorporated sustainable investing strategies or integrated ESG factors into their processes. Meanwhile, larger traditional asset managers will increasingly integrate SRI principles into their investment process in order to boost returns. Nevertheless, there is a growing need to boost the supply of SRI investment proposals to meet the expected demand with more familiarization among finance professionals to engage successfully with clients when distributing information about SRI opportunities. Conversely, although fund fees have dropped in recent years, the fees for SRI strategies are naturally higher than passively managed funds as managers charge higher fees to counterbalance their need to monitor corporations’ activities to ensure that the criteria of the fund are being maintained. Higher fees can have a material effect on performance. Still, in general, the SRI momentum has influenced the adoption of responsible or impact investing strategies by several institutional investors, and numerous quasi-sovereign institutions have well-defined SRI policies: »» The Canadian Pension Plan completely integrates ESG into its investment decision-making approach. »» The Norwegian Sovereign Wealth Fund (Norges) deploys exclusionary screening and active corporate engagement to enhance the practices of its investee companies. »» Adoption in the United States has generally been slower than Europe; nonetheless, a notable exception is the Ford Foundation, which has pledged to invest US$1 billion of its endowment into mission-driven impact investments. CHAPTER 7 Approaches to ESG Investing 123 »» In his 2020 annual letter to company CEOs, BlackRock founder Larry Fink, as head of the largest asset management company in the world, publicly demanded that every company show how it makes a positive contribution to society. »» Morgan Stanley has created the Institute of Responsible Investing, which is tasked with integrating SRI strategies across all departments of their business. »» Many conventional asset management firms have launched impact investment funds, including Apollo, Bain Capital, KKR, TPG, and Wellington. However, investors need to differentiate between those strategies that they feel have been created as asset gathering tools versus those with a discernible track record of creating genuine impact. At the extreme, Chapter 6 covers issues around greenwashing and what needs to be monitored for that issue. Otherwise, undertaking some due diligence on the SRI or impact credentials of a fund can highlight what track record or experience it has in the field or whether it’s jumping on the bandwagon. Evaluating Impact Investing The demand for impact investing — covered in this section — has resulted from the continuation of substantial societal challenges (for example, demographic changes, inequality, social exclusion, and unsustainable development) and the failure of current institutions, such as governments, charities, non-governmental organizations (NGOs), and philanthropic organizations, to meet those challenges. Unlike SRI or ESG investing, impact investing isn’t just about sidestepping sin stocks or “doing no harm,” but also actively employing capital to tackle social and environmental objectives while creating financial returns for investors. It requires purpose, where portfolio companies must proactively track, measure, and report on their social and environmental impact. Where successful, impact investing is releasing significant capital from mainstream investors. Defining and tracking “impact” Despite the growing interest in such goals, more recently driven by the identification of the UN Sustainable Development Goals (SDGs; see Chapter 1), there is still no agreement on what impact investing specifically covers, which is reflected in the wildly different estimations in the size of assets under management from industry representatives such as the Global Impact Investing Network (GIIN) and the Global Sustainable Investment Alliance (GSIA). The SDGs are commonly 124 PART 2 Investing in ESG through Different Instruments highlighted as part of the impact frameworks that investors are creating, using them as a road map to help recognize where investment opportunities lie or how their current investment methodology aligns. They help investors communicate the contribution that they are making to provide solutions for the biggerpicture questions that society faces and to facilitate a unified stance for the industry. Impact investing is an approach to investing in initiatives, organizations, and funds that pursue the development of both financial returns and quantifiable social and environmental impact. Investors pursuing financial returns and impact refer to this as the “double bottom line,” borrowing an accounting term to convey how both facets need to be measured and reported. Impact investments are frequently made through closed-end private equity and venture capital funds, whereby debt funds have seen increasing popularity, more recently among impact investors. A number of traditional private equity firms have opened dedicated funds, introducing billions in new capital and pulling in institutional investors. Furthermore, this interest isn’t only coming from the “usual suspects,” such as foundations and health- or faith-based organizations, which have a natural disposition to consider impact. Mainstream institutional investors, including corporations and pension funds, are also showing real enthusiasm to be involved. In the UK, the private Social Impact Investment (SII) market peaked in 2019; however, the pandemic has hit activity in the SII market harder than the broader investment market, with a 25 percent drop in the number of announced deals completed in the UK in the first half of 2020, compared to the same period in the previous year. Nevertheless, greater activity is expected to rebound as impact investors look to support the economic recovery post-pandemic. The difficulty in tracking “impact” is an issue that still hampers the development of this market, as uncertainty remains with respect to precise definitions of positive impact. Such definitions vary as investors tend to track outcomes with their own distinctive metrics based on specific objectives, which may also vary at different parts of the investment cycle. Following are some of the measurement methods used to determine impact: »» Expected return method evaluates the estimated benefits against the projected costs to determine which investment yields the highest impact. »» Theory of change method outlines the projected process to realize social impact, using a tool that maps the connections between input, activities, output, outcomes, and ultimately impact (logic model). »» Mission alignment method measures the implementation of the project against its mission and end objectives over time, using scorecards to scrutinize and govern key performance metrics on finances, operational performance, organizational efficiency, and social value. CHAPTER 7 Approaches to ESG Investing 125 »» Experimental and quasi-experimental methods represent after-the-fact assessments that use randomized control trials to conclude the impact of an intermediation compared to the situation if the intermediation hadn’t taken place. Measuring social and environmental outcome targets Investing for return and impact is complicated, as many projects targeted at social and environmental challenges are relatively expensive without having immediate or explicit financial returns for investors; as a result, compromise is typically expected between returns and impacts. Consequently, international best practices and models for impact investing should be categorized and analyzed. Based on insights from past projects, sound methodologies can be created to facilitate identification of prospects that can produce measurable market rate financial returns and social and environmental impact. Practical lessons should also be drawn from past projects to determine how to fruitfully engage with optimal opportunities. For an impact evaluation, it’s difficult to categorize projects that are both realistic and measurable. Focusing on overly elaborate projects may be counterproductive as it may take many years and require a controlling stake in the entity in order to achieve meaningful impact. Therefore, rather than chasing multifaceted targets, it may be better to emphasize projects with a higher probability of success that can be achieved in a relatively short time frame. In addition, targeting impact goals that can be certified and audited by third-party entities and adhere to ISO (International Organization for Standardization) standards is important in the long run. (Examples can be found in this article: www.responsible-investor.com/articles/ the-world-s-official-standards-body-has-begun-writing-sustainablefinance-rules.) For impact investing to scale, products must be able to address the breadth of institutional requirements, comprising the capacity to absorb large pools of capital, and provide sufficient liquidity and stringent risk management practices, while producing measurable return and impact. These have usually been provided by investment strategies targeting blue-chip securities, primarily bonds. However, this results in directing funds to investments where it’s harder to proactively produce impact, as bondholders and minority shareholders have fewer opportunities to directly influence senior executives of large corporations. Moreover, bluechip securities are concentrated in mature markets, whereas the maximum need for impact capital is in emerging markets or less established areas. 126 PART 2 Investing in ESG through Different Instruments Conversely, research shows that specializing in fixed income does allow opportunities to scale up impact investments. In particular, a focus on emerging markets, servicing principally undercapitalized small and medium-sized enterprises (SMEs) in developing countries, highlights the opportunities in less efficient markets where better arbitrage opportunities may be found. Calculating impact metrics Although the commercial world has several universally acknowledged tools, such as the internal rate of return, for evaluating a potential investment’s financial yields, no equivalent exists for calculating social and environmental rewards in dollar terms. Projecting returns is often a matter of conjecture. For example, the reporting of ESG issues is now standard practice at the majority of large and midcap corporations, but this is usually restricted to information about commitments and process, and seldom scores actual impact. Impact investing has been described as the “third stage of responsible investment,” succeeding the stages of ESG integration and risk management. Nonetheless, the measurement of positive impact of products and services is still comparatively new, with methodologies and protocols still being established. There are a series of methodological challenges in the data, including concerns over the borderlines of corporate reporting and the capacity for “double-counting” of impact data, reporting over consistent time frames, and correctly evaluating or guesstimating product- and service-level impacts. Consequently, a number of obstacles need to be overcome first. Methodologies need to be standardized, and data quality and equivalence need to be substantiated, as more than 130 impact measurement initiatives need to be considered. While widespread research has been conducted in this area, the evaluation of impact normally incorporates a number of identifiable metrics that the investors consider to be applicable to the social or environmental issue being tackled. Both impact funds and traditional asset managers are initiating annual reports that monitor the development of such metrics during the life of the investment. One example of the research undertaken in this field is that conducted by the Impact Management Project, a collaborative, multi-stakeholder endeavor facilitated by Bridges Fund Management, an impact investment firm founded in 2002, and funded by such large institutional investors as BlackRock, Hermes Investment Management, and PGGM. They have considered five dimensions of impact: what, how much, who, contribution, and risk. Another example is the Harvard Business School Impact-Weighted Accounts Project, which aims to drive the creation of financial accounts that reflect a company’s financial, social, and environmental performance (visit www.hbs.edu/impact-weighted-accounts/). CHAPTER 7 Approaches to ESG Investing 127 In addition, NEF (the New Economics Foundation) has developed a framework based on cost-benefit analysis, social accounting, and social auditing, with the goal of capturing social value by transforming social objectives into financial and non-financial measures. Social return on investment (SROI) analysis is a process of understanding, measuring, and reporting on the social, environmental, and economic value that is being created by an organization. SROI measures the value of the benefits relative to the costs of achieving those benefits by creating a ratio between the net present value of benefits and the net present value of the investment. This provides a further framework for exploring an organization’s social impact, in which tangible monetization plays an important, but not exclusive, role. You can find information on how SROI could help organizations better understand and quantify their social, environmental, and economic value here: www. nefconsulting.com/our-services/evaluation-impact-assessment/proveand-improve-toolkits/sroi/. Focusing on Faith-Based Investing In many ways, faith-based investing — discussed in this section — was the original forerunner of socially responsible investing and subsequently impact investing. Therefore, the exponential increase in assets under management and a general interest in ESG principles and framework have naturally led to increasing awareness of faith-based strategies. Reviewing religious principles of finance Investors looking to invest in a manner coherent with Christian values frequently consider avoiding investing in companies that support non-Christian approaches — for example, from supporting abortion to building controversial weapons. Alternatively, they often favor firms that support human rights, environmental responsibility, and fair employment practices via the support of labor unions. The top three SDGs that faith-based investors seem to favor include decent work and economic growth (Goal 8), affordable and clean energy (Goal 7), and reduced inequalities (Goal 10). These SDGs also appear as top themes for impact investors in the GIIN’s flagship research report summarizing the largest industry survey of impact investors. The harmony between faith-based investors and impact investors’ concentrations in the same SDGs implies that there are opportunities for these entities to collaborate on common social and environmental goals. 128 PART 2 Investing in ESG through Different Instruments This is particularly true where impact investors can support faith-based investors in mobilizing more of their capital to realize positive, measurable, social, and environmental impact results. Multiple entities now provide assistance in investing in a manner that supports Christian values, and mutual fund firms and other funds are committed to such parameters for investors who don’t want to take the do-it-yourself approach. Indeed, faith-based investors are often ahead of the game when spotting potential alpha in certain trades because they are engaged earlier than other investors in issues such as climate change, where they consider the issue to be morally unacceptable. Before such investments appear on the radar of ESG investors as materially relevant, faith-based investors may have already excluded such entities from their portfolios or begun an engagement exercise. Meanwhile, investors specifically looking to pursue Islamic religious principles normally avoid so-called sin stocks, such as those issued by firms that profit from alcohol, pornography, or gambling, and investments in pork-related businesses are also prohibited. They are also forbidden from owning investments that pay rates of interest on their funds, or companies that receive a significant part of their revenue from interest payments. As an extension of this, many Islamic investors also try to avoid companies that carry heavy debt loans (and therefore pay considerable amounts of interest). Examining exclusion screening and divesting Faith-based investors from many faiths were at the vanguard of negative screening and divestment strategies, given that they were intentionally and publicly eradicating from their portfolios corporations whose practices were against their convictions. For example, in the 1970s and 1980s, such investors divested from Dow Chemical to protest against its production of Agent Orange, and from South African companies in response to their support of apartheid. Even more so today, considering the “no harm” principles of faith-based and ESG investors, portfolios are constructed to specifically exclude certain companies that produce goods or services considered to do social or environmental harm. These generally include sectors such as alcohol or tobacco, as mentioned in the previous section. Some large and well-known funds, such as the Norwegian Sovereign Wealth Fund, have their own exclusion list, which excludes firms engaged in “unacceptable greenhouse gas emissions,” due to their involvement in oil sands production, for example. CHAPTER 7 Approaches to ESG Investing 129 Moreover, when considering whether to include negative screening in an investment strategy (and which sectors or stocks need to be excluded), investors also need to determine the quantity of the portfolio that they are considering. Within a fund structure, this might only apply to the fund’s passive investments, or where they don’t have direct control. Alternatively, it might be related to all assets in the fund structure that require compliance of all the underlying active managers. Positive screening is a comparatively new, but progressively popular, investment approach that involves actively seeking values-aligned investments for your portfolio by using ESG ratings to identify best-in-class stocks. Negative screening is purely an exclusion process to remove unsuitable stocks, whereas positive screening allows investors to add stocks to their portfolio that are considered to be positively engaging with ESG factors. Advocating for values through proxy voting Shareholder advocacy calls for investors to use their voices as “part-owners” to influence demands for socially or environmentally responsible company policies and practices. Through discussion and meetings with company management, shareholders should directly support the adoption of good corporate governance and socially responsible approaches. Investors should also consider filing shareholder proposals that would be voted on at the company’s annual general meeting. Many faith-based investors are active participants in order to ensure promotion of corporate social responsibility. However, for those investors interested in bringing a company to task, there are minimum threshold levels that apply to ensure that a filing is submitted, which varies according to jurisdiction. The types of thresholds include a minimum monetary holding and/or percentage holding in the company or a minimum number of shareholders who support the proposal. The requirements to be met should be available on your local regulator’s website — for example, www.sec.gov/news/ press-release/2020-220. Investors should also actively vote on proposals submitted by management or other investors in advance of company annual meetings, or ensure that their proxy vote will be submitted by a delegate. Similar to exercising your democratic right to vote, investors should carefully review their annual proxy materials to consider how they should vote on given proposals. Historically, this has been something of a “rubber stamp” exercise to reinstate specific board members whose terms had elapsed, or to confirm the auditor company assuring the accounts. However, with increasing activism, those issues and others are being questioned. If you have concerns over the performance of a company, this is usually your main opportunity to make your voice heard, particularly with respect to topics such as executive pay. 130 PART 2 Investing in ESG through Different Instruments Central to ESG integration is engagement with the underlying asset managers to confirm that the managers are determined to improve their ESG integration practices over time, and also to ensure that the asset managers are engaging with underlying company management teams to influence their behavior in a way that is supportive of good corporate governance, environmental policies, and social practices. For further information, visit https://partners-cap.com/ publications/a-framework-for-responsible-investing. Alternatively, many large shareholders engage an external investment advisory service that, in addition to providing investment advice, will liaise with the thirdparty asset managers to scrutinize and foster adoption of policies in support of the investors’ desires for impact and ESG-related investing standards and engagement with company management. The primary advisory firms are Glass Lewis and ISS, but given that some firms play such an important role in shareholder voting, particularly in the United States, regulators have started to impose restrictions on some of their activities. CHAPTER 7 Approaches to ESG Investing 131 IN THIS CHAPTER »» Creating a plan to develop a policy »» Participating in a peer review »» Reviewing your core investment principles »» Getting familiar with ESG-specific standards »» Checking out reporting requirements »» Starting ESG engagement Chapter 13 Devising an ESG Policy A sset owners are the economic owners of assets and include pension plans, insurance companies, official institutions, banks, foundations, endowments, family offices, and individual investors, each of which has different investment objectives and constraints. Asset owners can invest in an asset either by purchasing that asset directly or by hiring an asset manager to invest on their behalf. When an asset owner utilizes the investment management services of an asset manager, such investments can be structured as separate accounts or commingled investment vehicles (for example, mutual funds). Asset owners make critical decisions about how their money is invested, including the following: »» Establishing investment policies (for example, investment objectives, asset allocation policies, and approaches to sustainability or ESG matters) »» Whether to manage their assets internally or outsource to an external asset manager »» How to handle their responsibilities as public company shareholders (for example, proxy voting policies, reliance on proxy advisors, and insourcing versus outsourcing of investment stewardship activities) CHAPTER 13 Devising an ESG Policy 233 This chapter looks at devising an ESG approach for an asset owner. Many corporations have adopted a purpose statement, which normally refers to their mission, primary goals, and core beliefs. Even though such statements are often communicated at a high level, the idea that they outline a longer-term horizon that they aspire to is comparable to the longer-term objectives needed for an ESG policy. Here’s a Great Idea: Creating a Plan Any document that is developed to show the intent of an organization in a given direction should start with a plan that establishes the short-term and long-term objectives of the company that need to be implemented in order to meet the organization’s ultimate ESG aspirations. This could begin with an analysis of the organization’s current approach and systems, which could be mapped to the overall objectives in order to identify obvious, initial gaps. This approach could be guided by interim targets for review, and tasks and frameworks set to enable implementation in a coordinated fashion. Some investors can struggle to communicate their approach, particularly smaller organizations that are new to the process. An initial approach taken by some is to refer to frameworks such as the UN Sustainable Development Goals (SDGs; see Chapter 1) and Principles for Responsible Investment (PRI) to help inform discussions and identify goals that map to the core high-level beliefs central to an organization. (Visit www.un.org/sustainabledevelopment/sustainabledevelopment-goals/ and www.unpri.org/download?ac=4336 for more information.) This can be combined with a statement of priorities that further defines any essential sustainable themes, in ESG terms, and that also enables mapping to potential investment opportunities. Clearly, some priorities may not be immediately investable, but confirmation of these requirements helps ensure that investors proactively investigate potential paths for investment in the future. Additional approaches to inform the process should include an internal review process, wider stakeholder consultation, and potentially the engagement of an external service provider. It’s important that the methodology employed be inclusive to ensure representation of all relevant and material assessments. Furthermore, it’s necessary to recognize that without well-defined core principles, the work of the trustee (who is responsible for ensuring that the assets are managed properly and that owners’ benefits are secure) and other fiduciary and regulatory requirements will be difficult to forcefully implement. As the plan begins to unfold, milestones should be present to ensure monitoring and evaluation of progress are in place to observe the organization’s development against the originally planned objectives. In addition, ownership of the policy and 234 PART 3 Applying ESG Philosophy results should be held by management at the highest level possible to ensure that cultural fit and organizational governance “buy-in” is maintained. The following sections outline some of the key considerations to develop an ESG framework. It’s important to involve all stakeholders and agree on an internal governance structure, some of which can be gleaned from a peer asset owner review, before determining the core investment strategy. Promoting ESG among key stakeholders The stakeholder model is increasingly followed as part of the stated purpose and vision of the asset owner. (Stakeholders in this situation include beneficiaries, employees, internal and external investment managers, trustees, and executive management.) Consequently, ESG metrics should be used to assess and evaluate investment performance and its comparative positioning on a range of topics applicable to the wider set of stakeholders, in a similar fashion to performance metrics being used to assess investment management performance for shareholders. It’s vitally important that ESG stakeholder metrics and goals are chosen and established with the same consistency as other performance metrics to safeguard that the realization of ESG goals will enhance stakeholder value and not serve simply as a “check the box” or “greenwashing” exercise (see Chapter 6). There is no “one size fits all” approach to ESG metrics, and asset owners invest across a range of asset classes that influence the type of ESG factors that are appropriate to short- and long-term investment performance and sustainability considerations. Implementing ESG metrics is an asset owner–specific design process. For example, some asset owners may choose to implement more qualitative ESG investment goals, even though they have rigorous ESG factor data and reporting, while others will consider quantitative ESG goals that integrate the new data elements (see Chapter 14 for more information on the integration of ESG factors). Creating an internal governance structure Core responsible investment guidelines can look very different from organization to organization, predominantly based on the responsible investment practices that fit with your organization’s investment process and philosophy. This may also be driven by differences relating to internally or externally managed assets, and dependent on the jurisdictional requirements and legal aspects that can affect the guidelines. For example, your organization may set minimum ESG standards that investee companies need to adhere to. Some investors may impose high-level requirements on ESG, while others may require specific information on how companies manage ESG issues, with minimum standards having to meet a broader industry CHAPTER 13 Devising an ESG Policy 235 standard. Similarly, standards can be set relative to different asset classes, which may differ relative to the ESG ratings available for listed equities, bonds, private equity, real estate, hedge funds, or commodities. Guidelines for working with external managers will tend to be more specific, as internal managers will, of course, be covered by already-set internal guidelines. External investment managers may be required to have their own responsible investment policies in place, or alternatively to adopt the asset owners’ policy. Some asset owners may extend this further to include guidelines on manager selection and monitoring, inclusion of ESG issues in Requests for Proposals (RFPs) for investment mandates, and requirements on reporting for ESG issues. Don’t Reinvent the Wheel: Undertaking a Peer Review Given that the principle of having an ESG or responsible investment policy in place is still relatively new for many asset owners, there is an understandable tendency to be interested in how other owners have approached the process rather than “reinventing the wheel.” In addition, understanding what your peers have done can encourage high-level investment policy discussions, which can further help the drafting of any policy. In principle, given the current assets under management, ESG investment practices should follow the same structure and consistency as more traditional items of an investment policy statement. Peer reviews provide guidance on how investment policies were formulated, and the outcomes they produced may be transparent. When considering how your policy compares to other approaches, it’s instructive to see how stakeholders are involved in the establishment of policy. In addition, you need to understand how ESG risks or opportunities are defined and identified, or how issues are weighed and evaluated in investment decisions. Interestingly, rather than just meeting the investment requirements for such a policy, some organizations also monitor the positive real-world influence achieved through their portfolio! The following sections consider peer reviews and different types of ESG investment strategies, including their identification, assessment, and selection. Devising ESG investment strategies There are five primary strategies for ESG investing: exclusionary screening, positive screening, ESG integration, impact investing, and active ownership. (You can 236 PART 3 Applying ESG Philosophy find out more about these strategies in Chapter 8.) Such strategies exhibit a wide range of intentions, from avoiding or reducing ESG risks to seeking measurable impact. They also exhibit a wide variety of investment and impact considerations that investors should take into account. Some objectives overlap other ESG strategies to some degree, and multiple ESG strategies are sometimes combined within a single investment vehicle to realize the unique goals of an asset owner. Moreover, these strategies can also be executed across asset classes and investment styles. It can be argued that much of the value of ESG as an investment framework results from predicting shifts in political and social priorities, which subsequently generate shifts in economic opportunities for investors. These shifts, while clearly significant from an ESG investing perspective, nonetheless introduce problems when developing metrics that anticipate changes in social norms that haven’t yet happened, and when estimating the social impact of any related changes in corporate behavior. The fundamental aspect of ESG investing is that a long-term time frame can be required to see how the trend plays out. ESG can be considered as an investment process, which suggests that markets and many companies are too short term in their assessment of value, and that by investing in its structure, people, and community, a company’s long-run performance should improve. Others argue that certain ESG risks are already financially material and should be considered regardless of your investment horizon. In fact, given the rapidly growing assets under management that follow responsible or sustainable investment strategies, some would argue that people shouldn’t be talking about ESG investing integration because ESG investment strategies will become the norm rather than the exception in the not-too-distant future. Based on this framework, you should publish your comprehensive investment strategy and principles so that the market recognizes that you’re committed to responsible investment practices that generally consider a long-term trend. Moreover, this incorporates ESG factors that focus on risk-management mitigation while also looking to uncover potential opportunities. Wherever your policies adhere to best-practice requirements, these requirements should also be highlighted to emphasize your awareness of their importance; such statements should at minimum be displayed on your website if not with other industry-relevant organizations. In addition, you should consider signing the internationally recognized Principles for Responsible Investment, which allows your organization to publicly demonstrate its commitment to responsible investment (see www.unpri. org/signatories for more information). CHAPTER 13 Devising an ESG Policy 237 Identifying, assessing, and selecting ESG investments Asset owners should fully incorporate ESG analysis into their investment process, incorporating initial screening, issue selection, portfolio construction, and risk management. They should also have transparent and well-implemented programs to actively engage with portfolio holdings on ESG stewardship (for more information, check out www.unpri.org/investment-tools/stewardship). Many sustainable funds take an integrative approach to creating their portfolio. Their emphasis tends to be on identifying stocks that have “best-in-class” practices when incorporating ESG issues relevant to that company. This tilts the portfolio toward companies that are generally managing ESG issues better than their peers and are thus less likely to face financial risks or controversies such as fines, lawsuits, and reputational damage. Negative (or exclusionary) screening is still used today, particularly by funds investing in line with religious values; however, the fact that this approach rules out established companies for non-financial reasons can lead to underperformance or cause issues when tracking an established benchmark index. An increasing number of funds state in their prospectus (the document that funds need to publish as a guide to their investment strategy, costs, risks, and management) that they make sustainability factors a featured component of their process when building their portfolio and choosing investments (known as ESG Focus funds). Another group, Impact funds, tends to focus on broad sustainability themes and on delivering social or environmental impact alongside financial returns. They tend to focus on specific themes, such as low carbon, gender equality, or green bonds (funding new and existing projects with environmental benefits; see Chapter 9). Lastly, Sustainable Sector funds concentrate on companies that proactively contribute to the transition to a green economy in areas such as energy efficiency, environmental services, renewable energy, water, and green real estate. Go Over It: Reviewing Your Core Investment Principles An Investment Beliefs Statement acts as a conduit between high-level goals and practical decision-making. Investment Belief Statements are valuable because they help trustees and fiduciaries clarify their views on the current state of financial markets in which they have to operate and how these markets are currently functioning. They outline the institution’s rationales for their selection of investment styles and managers, while considering the core investment principles that 238 PART 3 Applying ESG Philosophy they apply in the investment process. Generally, your responsible investment principles should be informed by these beliefs and this strategic investment approach, and reflect your organization’s culture and values appropriately, in the ESG policy. Trustees and fiduciaries will be guided by these core principles to ensure that oversight and accountability measures are implemented. Some of the guiding thoughts when reviewing your beliefs and principles should include considerations on the value of diversification (and what impact screening may have), which types of risk should be included (and whether ESG factors help mitigate them), what ESG factors are considered material to investment returns, and whether they reflect a risk or an opportunity. Do you adhere to a long-term investment outlook, and are your general principles applicable to your entire asset base, or does it vary for given asset classes? And how do you view impact investing and its potential to benefit people or the planet? Does this lead you to invest thematically, for example, by focusing on low-carbon investing principles? Good corporate governance is ensuring appropriate oversight of the company’s functioning in pursuit of its corporate objectives for the benefit of its stakeholders. However, fundamentally this should be built on three pillars: economic progress, social development, and environmental improvements. Therefore, good governance ultimately promotes sustainability by generating sustainable values and helping companies adhere to their values. It also helps companies realize long-term benefits, including diminishing risks, attracting new investors, and growing the companies’ equity. So, as the pursuit of corporate sustainability continues to enrich and expand the principles of good corporate governance, companies will feel compelled to boost their efforts with greater transparency and public disclosure. In turn, transparency efforts will deliver information to investors on the relationship between corporate governance and improved sustainability. There is increasing evidence that the support of shareholder preeminence encourages company directors to adopt the same short-time horizon thinking as with the financial markets at large. The suggestion is that pressure to meet the demands of the financial markets drives stock buybacks, excessive dividends, and a failure to invest in productive capabilities. This prompted the European Commission to produce the Action Plan on Financing Sustainable Growth (see https://ec.europa. eu/info/business-economy-euro/banking-and-finance/sustainablefinance_en), which sets out a bold agenda to advance integrated reforms in the areas of corporate reporting, directors’ duties, and sustainable finance, with a target to address the reorientation of financial flows to more sustainable outcomes. The principle is to correct the failure of companies to manage the financial risks associated with climate change and to encourage a move toward greater sustainability. CHAPTER 13 Devising an ESG Policy 239 Since 2018, the EU Non-Financial Reporting Directive (NFRD) has required large companies, banks, and insurers to disclose non-financial information (see https://ec.europa.eu/info/business-economy-euro/company-reportingand-auditing/company-reporting/non-financial-reporting_en#review). However, due to a plethora of standards and the flexibility given to reporting entities, this reporting isn’t currently comprehensive or sufficiently comparable. The NFRD review of its legislation is aimed at addressing some of these issues, but the amendments have been delayed due to COVID-19. Therefore, the standardization of non-financial reporting will benefit the development of sustainable finance, as it enables comparability of information across investments. Familiarizing Yourself with ESG-Specific Regulations In general, local jurisdictional law may compel pension funds to have a statement of investment principles, or their fiduciary duty may require trustees to reflect on any ESG issues that are financially material. In addition, other jurisdictions may explicitly oblige diversity and inclusion to be considered as material ESG factors in their investment analysis and decision-making. Therefore, due to this growing acceptance of responsible investment practices, most pension funds already advocate many forms of ESG investing. Also, in many countries, the corporate governance and stewardship codes give valuable insight into ESG policies, which should consider the performance of investment portfolios to variable degrees across companies, sectors, regions, and asset classes. Furthermore, many of the points mentioned here for money managers will be comparable for individual companies implementing their own ESG policies. The following sections compare the regulation in the two major jurisdictions with the largest ESG assets under management, as well as look at the associated sustainability risks and how the issues around “greenwashing” are being addressed. Comparing Europe and the United States Europe has been leading the way with a virtual legislative tsunami of regulation, resulting in a range of important rules for asset managers, either as publicly listed companies with new ESG disclosure requirements or explicitly relating to their role in the design, delivery, and sale of financial services and products. This seems to reflect regulators’ recognition that certain ESG factors are financially material 240 PART 3 Applying ESG Philosophy and should be explicitly considered, as well as a desire to ensure the finance sector reorients capital flows. Depending on the nature of their business, type of client, and activities, asset managers face new requirements at the corporate governance, process, and product levels. In response, by the end of 2020, the number of asset owners, investment managers, and service providers that were signatories to the Principles for Responsible Investment had reached more than 3,000, up more than 50 percent from 2018. Asset managers are at the center of this challenge, but they face diverse approaches and variable definitions of sustainability concepts set forth by asset owners, business sectors, jurisdictions, and professional and industry standards–setting bodies. Without reliable definitions, it’s difficult to establish the data points needed to set equivalent targets, monitor investments, and evaluate and compare performance against peers, let alone across the financial services sector, and national or regional borders. Moreover, asset managers must present this in-depth data analysis to fulfill their own corporate reporting requirements, to manage applicable investment and risk management decisions, and to make disclosures to clients and fund investors. The challenge is compounded by the fact that asset managers typically need to review endless subsets of relevant ESG considerations for multiple, distinct asset classes, industries, and geographies. In the United States, some accuse the federal government of standing still on ESG, as no blanket mandatory requirements have been imposed. However, certain states are leading the way on substantive regulation designed to encourage sustainable investment. These states are leaning into the market’s growing focus on managing capital using ESG factors to further regulate pension systems, trust funds, and board composition. In turn, this is making ESG even more important for those raising and managing funds across the liquidity spectrum. The most proactive state pension systems promoting these activities have been California’s Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS). Taking into account sustainability-related risks Sustainability risks are growing and getting more attention from executives, investors, lenders, and regulators. Examples of where they exist include threats to operating licenses in mining operations, assessments of overconsumption of water, reputational risks linked to investments in projects with potentially damaging environmental consequences, risks to financial performance from volatile energy prices, compliance risks triggered by new carbon regulations, and risks from product substitution as customers switch to more sustainable alternatives. CHAPTER 13 Devising an ESG Policy 241 Executive attitudes toward sustainability are gradually changing. Sustainability has historically been viewed as a cost center, a corporate social responsibility (CSR) issue complete with obligations to meet requirements from climate change goals to charitable donations to local communities. However, more firms are viewing sustainability through the lens of market opportunity and value creation. They now have the financial data to support this assessment with the establishment of new markets and business models associated with sustainability trends. Tangible financial results from such strategic plans will take time to appear, but some of the world’s leading brand managers have been converted. Therefore, sustainability risk management (SRM) is emerging as a business strategy that affiliates profit goals with internal green strategies and policies. These policies seek to diminish negative environmental impact by shrinking the use of natural resources and cutting carbon emissions, toxic substances, and by-products. The goal of SRM is to make this alignment sufficient to sustain and grow a business while still preserving the environment. SRM is now considered a vital part of enterprise risk management. Doing effective due diligence on ESG greenwashing All kinds of businesses and brands are starting to use the word “sustainable” in their marketing. Whether it’s a T-shirt made of ethical cotton or an “eco” car, companies are increasingly keen to showcase their green credentials. So, how can you tell the difference between real, positive commitments to change and “greenwashing”? In the current environment, greenwashing (covered in detail in Chapter 6) can take two main forms: »» One is where a company is trying to hide or cover up their questionable environmental records with an impressive public gesture toward green causes. However, in the age of social media, these big PR campaigns are often criticized and scrutinized pretty quickly. »» Harder to spot and far more underhanded, the other form is where companies and brands use words like “green,” “sustainable,” “eco-friendly,” or “vegan” simply as a marketing ploy, without any real commitment to the principles and certainly without any accountability for their actions. Investment products aren’t immune to greenwashing. Asset managers have seen the opportunity to attract money from investors as the demand for ESG-related products has exponentially increased. They claim to have integrated environmental, social, and governance considerations into their investment processes, but 242 PART 3 Applying ESG Philosophy because ESG investing is still somewhat new, the capacity of investment managers and investors to assess the materiality of stated ESG factors is evolving. Therefore, it’s vital for asset owners and advisers to question a fund’s ESG approach and identify any potential greenwashing by the fund manager. Certainly, the Markets in Financial Instruments Directive (MiFID) II legislation in Europe obliges advisers to question clients on their ESG preferences when conducting their research, based on a 2020 amendment to MiFID II. In addition, the U.S. Securities and Exchange Commission (SEC) has openly criticized the asset management industry’s reliance on a single rating for ESG funds data as “imprecise,” due to concerns that overly simple ratings systems are leading to misinformed or even misguided investment decisions. Some may consider this misinformation as an additional consideration in their greenwashing monitoring. Surveying Reporting Requirements Broader elements of reporting requirements are covered in Chapter 14, but this section contains a condensed view of the considerations required. A plethora of reporting frameworks, standards, and guidelines are available, to the point that it’s difficult to know which one to select: »» Some frameworks, such as the Global Reporting Initiative (GRI), are not industry-specific, while the Sustainability Accounting Standards Board (SASB) is industry-specific. »» However, the GRI and SASB are discussing potential collaboration around reporting requirements. (Chapter 1 has more about the GRI and the SASB.) »» Other standards can be more topic-specific, such as the Task Force on Climate-related Financial Disclosures (TCFD), which focuses on climate change, and the Global ESG Benchmark for Real Assets (GRESB), which is a standard that is more specific to the real estate industry. However, there is no one-size-fits-all approach, and it depends on your organization’s reporting needs, what you want to report, and whom you are reporting to. It can be a struggle to accurately collect and report quality sustainability and ESG data, but you need to ensure its reliability and accuracy. CHAPTER 13 Devising an ESG Policy 243 Essential characteristics of ESG data According to a survey by IHS Markit, a large data provider, seven of the top preferences sought by fund investors on how ESG metrics/data are commonly reported are to »» Develop consistent and controlled policies for quantifying and reporting purpose-led metrics. »» Align metrics reported externally with those used by management in running the business. »» Organize metrics in a systematic way (that is, using technology to make the information interactive and engaging). »» Offer comparison figures to demonstrate consistency. »» Determine the appropriate format and frequency of reporting. »» Implement controls over the preparation and reporting of purpose-led metrics with the same rigor as controls over traditional financial reporting. »» Provide context (for example, the most relevant metrics consider the entity’s industry and markets). Material factors for investors While the approaches in the preceding section are being widely employed, and the World Economic Forum (WEF) guidance — to include a full set of metrics in your corporate and financial reporting — represents a well-intentioned route to defining broader ESG metrics, measurement, and quality of ESG data remains an issue. There are several areas of ESG endeavor that aren’t embodied in easily reportable figures and that don’t have commonly accepted measurement criteria. Attempts to fill these gaps could include establishing a formal environmental policy and highlighting the management team’s competence in observing and tackling the environmental costs of corporate operations. Separately, the capability to estimate carbon emissions, both direct and indirect, including those generated by their wider value chain, would be information that investors would find useful. Where there is a legal requirement for disclosure, such as the gender pay gap in large companies, data is easier to compare but still prone to inconsistencies and limited in scope. Timing is another issue, where without real-time reporting factored in and consequent adjustment of rankings, a company could continue to score highly after a suffering an ESG crisis. Furthermore, the lack of traceability of source material in the current systems throws further doubt on its reliability. 244 PART 3 Applying ESG Philosophy Examining ESG Engagement Asset owners should actively use their ownership rights to engage with companies or look for their asset managers to engage on their behalf in a constructive manner. Improvements in sustainable corporate behavior can lead to an enhanced risk/return profile for any investments. Engagement aims to improve a company’s ESG approach with the aim of boosting the long-term performance of the investment. The outcomes of engagement efforts need to be communicated to analysts and portfolio managers to ensure they incorporate the information into their investment decisions as part of an integrated sustainability investing framework. The first criterion is that engagement should be relevant with respect to the investment exposure. Developing a materiality framework can be a starting point to prioritize potential engagements, with materiality insights determining the most relevant sustainability risks and opportunities to be addressed. Sustainability should be viewed as a value driver alongside other components such as company financials and market momentum. The management and board of listed companies that have strong sustainability and governance policies have proven to better manage issues such as non-financial risks and changing regulation. Consequently, they also seem better prepared to cope with long-term trends such as climate change. The following sections consider approaches with respect to engagement that asset owners should consider and the type of companies that could be candidates for earlier-stage ESG analysis. Conducting constructive dialogue on managing ESG risks Engagement should entail a constructive dialogue between asset owners and managers and investee companies to review how they manage ESG risks and grasp business opportunities associated with sustainability challenges. Such conversations can be managed in a reactive manner, to review specific incidents, or in a proactive manner, to improve potential risks and opportunities. The level of commitment involved is generally related to the size of the investment in a company and the situation that the company is dealing with. Where an owner is a major shareholder, engagement should be undertaken directly with the company; however, if the shareholding is smaller, this could be done in cooperation with other investors. Ordinarily, engagement is on a corporate level, but the World Bank Treasury team has also been proactive in facilitating open and productive dialogues between CHAPTER 13 Devising an ESG Policy 245 institutional investors and sovereign bond issuers around ESG issues. Building on experience from the equity market, investors are investigating ways to support and develop their ESG approaches across asset classes, including investments in sovereign bonds, to enrich risk management and returns while achieving a positive impact. Investors that are developing ESG risk assessment and portfolio selection frameworks to evaluate sovereign issuers based on ESG criteria are interested in learning about countries’ ESG policies, strategies, and approaches. They also need to analyze data on sovereign ESG performance and assess progress on the SDGs and Paris climate commitments. World Bank Treasury syndication is supporting some of these activities to enhance the access and engagement with sovereign bond issuers. Maintaining a dialogue is resource-intensive but has been proven to be effective, so it should continue to be a high priority. ESG and sustainability are increasingly ingrained in institutional thinking, and gradually more in private investments. Seizing business opportunities associated with sustainability challenges Change can feel threatening, but applicable strategies and successful management can bring momentum to organizational transformation and, in turn, new business opportunities. Companies that are receptive and start planning now can ensure an early competitive advantage. However, this isn’t without challenges, including an ability to reframe the sustainability strategy emphasis from mitigating risks to embracing opportunities by inserting sustainability into the heart of their business model and scrutinizing its future feasibility. Asset owners can contribute to the transition process by engaging with those firms that they believe would benefit most from an improved sustainability approach and share with them some of the best practices employed by their peers. Alternatively, owners should encourage their asset managers to engage further. The majority of companies agree that sustainability is an important factor for long-term business success, but they aren’t identifying developments that will positively inspire current and future development, which should be used to form a clear strategic direction. The current global economic situation means that companies have an opportunity to reframe their strategic perceptions and build effective management structures and systems to rationalize and redirect corporate sustainability responsibility into clear metrics, tangible action, and quantifiable performance. Asset owners could, either directly or indirectly, promote a greater focus on sustainability opportunities. 246 PART 3 Applying ESG Philosophy Asset owners’ fiduciary duties require them to pay attention to ESG issues in their investment processes and to actively engage with companies. Therefore, once the risks and opportunities have been identified, owners need to encourage companies to implement targeted action. This process can start by considering accepted approaches in new ways in order to improve operational and eco-efficiency. This allows corporate sustainability to build on process improvements and investment into effective technologies such as waste avoidance and energy and resource efficiency. The next step is to consider adopting new ways to promote efficiency and achieve conclusive improvements and targets such as carbon neutrality. These measures are increasingly seen in the private sector — for example, with respect to setting carbon targets. In this step, sustainability measures should aim for the decoupling of operations from environmental impacts. Certainly, this process is a continuously evolving circle in which asset owners can work with companies to gradually develop further sustainable transition. CHAPTER 13 Devising an ESG Policy 247 IN THIS CHAPTER »» Studying criteria and metrics »» Figuring out relative ESG performance »» Reviewing ratings and rankings »» Building frameworks for reporting Chapter 14 Defining and Measuring ESG Performance and Reporting R eports and studies from a range of sources, from academics to investment banks, continue to reveal that portfolios based on investing in companies with high ESG metrics would have beaten the broader market by impressive amounts every year for the last five to ten years! In response, databases with countless ESG indicators exposing numerous corporate attributes have sprung up, suggesting that a targeted approach to both understanding and utilizing ESG data is necessary. Given the large number of ESG indicators, investors have tended to outsource their requirements in order to improve their assessment. While many rating agencies provide a single ESG score for an individual security, comprising a composite of different individual factors, using such metrics to assess a single holding or a given portfolio indirectly presumes a shared set of ESG values across investors. However, what is socially responsible to one investor may not be to another. In addition to deciding which ESG factors to converge on, CHAPTER 14 Defining and Measuring ESG Performance and Reporting 249 investors need to establish how to calculate the relative value of a given ESG metric. Three primary approaches currently exist: »» Referencing against peers managing equivalent portfolios »» Evaluating against a common benchmark index »» Comparing against the investor’s own history The relevance of any of these approaches is contingent on an investor’s specific situation, including, for example, the risk profile of the portfolio, the alignment of stakeholders, and any fiduciary responsibilities. This chapter elaborates on how to define the criteria and metrics for material ESG factors and how the frameworks for related reporting of the data behind such factors continue to be developed. These elements provide the background to how the market is calculating relative ESG performance and the associated ratings and rankings. Defining Criteria and Metrics ESG factors are used in public market portfolios in many different ways, with some active managers using ESG factors as an integrated part of their investing process. Active managers generally look for financially material ways to integrate ESG factors (such as revenue growth, margins, or required capital). Passive investors can accept financially immaterial ways to integrate ESG factors (given that they are normally accepting the constituent stocks of a given index exposure). Examples of financial immaterial methods are those that don’t have a significant impact on a company’s business model but that may be relevant from a general sustainability perspective. However, when analyzing the ESG score of a passive portfolio, an investor can choose to use factors to better align the portfolio with their values by considering indexes that emphasize specific characteristics, such as a higher ‘E’ score for companies with lower carbon emissions practices (see Chapter 8 for more information). The following sections look at how corporations have to comply with regulation, what criteria that entails for sustainability reporting, how this is driving corporate social responsibility practices, and how that influences the metrics around associated corporate performance. 250 PART 3 Applying ESG Philosophy Follow the rules: Looking at regulators’ work As with any investment strategy, investors need to determine their risk-andreturn objectives. In an ESG-aware passive portfolio, indications of risk tolerance are important, as higher levels of concentration or tracking error can result from using given ESG metrics to negatively screen (exclude) or proactively bias a portfolio toward a specific ‘E,’ ‘S,’ or ‘G’ direction. With increased data accessibility, technology, and advanced risk management techniques, it’s easier for investors to apply ESG factors to enhance alignment of their portfolios with their values, while keeping an eye on increased concentration issues, tracking errors, and risk considerations. Conversely, the discrepancy among ESG ratings from different providers has motivated regulators on both sides of the pond to create more standardized frameworks and hopefully bring more transparency. The view was that uncertainty around ESG ratings was slowing the progress of determining sustainability market issues. Therefore, in May 2020, the investment committee of the U.S. Securities and Exchange Commission (SEC) proposed an ESG disclosure framework for consistent and comparable information, without the use of a third-party rating agency, to disclose material information that investors can rely on to make investment and voting decisions. Meanwhile, in Europe, three interconnected regulatory approaches were also introduced recently: »» The Non-Financial Reporting Directive (NFRD), which is currently under review, requires large EU “public interest” corporates to publish data on the impact that their activities have on ESG factors. See https://ec.europa.eu/info/ business-economy-euro/company-reporting-and-auditing/companyreporting/non-financial-reporting_en#review for details. »» The Taxonomy Regulation introduces a sustainability classification tool aimed at investors, companies, and financial institutions to define the environmental performance of economic activities across a wide range of industries through which investment firms must classify investments based on NFRD data (and other datasets). Visit https://ec.europa.eu/info/business-economy- euro/banking-and-finance/sustainable-finance/eu-taxonomysustainable-activities_en. CHAPTER 14 Defining and Measuring ESG Performance and Reporting 251 »» The Sustainable Finance Disclosure Regulation (SFDR; see https://ec. europa.eu/info/business-economy-euro/banking-and-finance/ sustainable-finance/sustainability-related-disclosure-financialservices-sector_en), as supplemented by the Taxonomy, requires investment firms to disclose the following: The environmental sustainability of an investment and the provenance of any ESG claims made The risks that investments present to ESG factors The risks that ESG factors present to investments Not to be outdone, in September 2020, the World Economic Forum (WEF) released a report, “Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation.” (Visit http://www3. weforum.org/docs/WEF_IBC_Measuring_Stakeholder_Capitalism_Report_ 2020.pdf). It’s aimed at producing a baseline set of corporate disclosures with the objective of driving consistency and standardization of disclosure. Their principles state that benchmarking sustainable business performance will be easier with a universal set of “stakeholder capitalism metrics,” including ESG indicators and disclosures for financial markets, investors, and society. The metrics will help companies demonstrate long-term value creation and their contributions to the United Nations Sustainable Development Goals (SDGs; see Chapter 1). According to the WEF, their efforts aren’t intended to replace any of the industry-specific ESG metrics that investors already use, and these metrics are complementary, rather than competing, initiatives. In addition, most of the investors that contributed to the consultation would like to see ESG reporting included in a company’s annual report. The devil is in the details: Analyzing corporate sustainability reports A substantial amount of ESG data on companies is self-reported, which can lead to significant breaks in the aggregate data that is used to generate an ESG score. Moreover, some of the factors aren’t sufficiently reported to encompass the universe of investable companies. For example, considering the new WEF disclosures (see the previous section), there is a potential requirement to report on 21 core metrics, or an expanded 35 metrics. Given that many of these metrics may not be deemed material to a given industry, or are too challenging to deliver, there is always a trade-off between complexity, standardization, and relevance. However, the WEF methodology is being reviewed by many leading disclosure and reporting standard-setters, including the Sustainability Accounting Standards 252 PART 3 Applying ESG Philosophy Board (SASB), the Global Reporting Initiative (GRI), the Carbon Disclosure Project (CDP), the Climate Disclosure Standards Board (CDSB), and the International Integrated Reporting Council (IIRC). Perhaps this is because the approach is intended to build on the existing frameworks from established providers, which in some cases cater to industry sector biases, rather than reinventing the wheel. The WEF metrics are built on four pillars, encompassing a number of ESG factors: »» People: Diversity reporting, wage gaps, and health and safety »» Planet: Greenhouse gas emissions, land protection, and water use »» Prosperity: Employment and wealth generation, taxes paid, and research and development expenses »» Principles of governance: Purpose, strategy, and accountability informing risk and ethical behavior So, companies are reporting on the aforementioned ESG metrics, and the WEF move signifies a further initiative toward consistency and standardization, but the measurement and quality of ESG data continues to raise more questions than answers. Self-disclosure reporting, which is supported by the WEF and others, is subject to inconsistency, bias, and opaqueness as it’s largely voluntary and still requires agreement on disclosure standards. Several areas within ESG activity aren’t characterized by easily reportable numbers, don’t have commonly accepted evaluation criteria, or simply don’t have accepted definitions. As such, this can still leave an incomplete ESG reporting picture. In addition, the significance and frequency of given areas of ESG activity differ from sector to sector, if not from company to company. High-level ESG metrics are accepted by investors, as they can be commonly applied across the majority of industry sectors, which allows a broad overview of their impact. Nevertheless, there is a danger of generalizing ESG reporting to a point that can be simply and reliably measured, rather than “digging into the weeds” to highlight more material matters. Walk the walk: Committing to corporate social responsibility practices The WEF suggestions around metrics and disclosures were produced in collaboration with the Big Four accountancy firms — Deloitte, EY (Ernst & Young), KPMG, and PwC (PricewaterhouseCoopers) — after consulting with numerous corporations, investors, international organizations, and standard-setters, and with the Impact Management Project (which provides a forum for building global CHAPTER 14 Defining and Measuring ESG Performance and Reporting 253 consensus on how to measure, manage, and report impacts on sustainability; see www.impactmanagementproject.com/). The intention is to offer a common set of existing disclosures that produces a more coherent, thorough reporting system and a statement of intent that complements established metrics. The benefit of non-financial reporting is to further highlight issues such as climate change and social inclusion. Therefore, companies can enhance their own corporate social responsibility practices (CSR; see Chapter 7) by demonstrating to shareholders, stakeholders, and society in general that they are committed to measuring and improving their impact on the environment and society. Interestingly, at the same time, the SEC approved changes to a shareholder proposal rule that substantially increase the ownership thresholds needed to file and resubmit proposals to company boards on ESG issues such as climate change, diversity, and excessive pay for board members. Given the positive moves made in other areas to promote ESG engagement, this amendment seems contradictory and diminishes the ability of smaller investors to highlight unsustainable practices. Shareholder resolutions are an established and effective approach to advocate changes to management, in addition to holding them accountable to make good on their CSR. Show me the money: Identifying investment performance ESG performance is a developing consideration in corporate valuations. In an environment where sustainability is increasingly central to business survival, companies are using ESG criteria to evaluate their non-financial performance. The development of ESG investment performance metrics has resulted in the compression of independent ratings systems, voluntary company self-disclosures along with mandatory company disclosures, annual reports, and intermittent media coverage. Even signing up to the UN SDGs places a voluntary commitment on companies to meet explicit ESG criteria, which are incorporated with investment analytics, management data, and ESG factor risks. These are all placed into an ESG “melting pot,” and an alphanumeric score is produced as a proxy of ESG performance. While nobody disputes that an ESG profile is both valued and broadly understood by many organizations, the capacity to link it to material outcomes is often missing due to the discrepancies in measuring it and the absence of a recognized methodology. Of course, the ability to incorporate the multiple aspects that can fall under the broad ESG umbrella into one indicator is challenging, as is the ability of a company to ensure that they are reporting on all of their potential liabilities. Added to this are the different risks that can be attributed to different sectors, if not the risk of failing to report on an ESG element that subsequently proves to be relevant, raising reputational risks for a company. 254 PART 3 Applying ESG Philosophy For now, performance will have to be viewed against ESG ratings, ranking companies against given ESG criteria and measuring their performance on a sustainability scale. However, no ideal solution exists for ESG scores, which therefore must be considered subjective, if not misleading, given the lack of correlation on certain companies between different rating agencies. Nonetheless, some new services are being offered that incorporate the use of Machine Learning — Natural Language Processing (NLP) technology in particular — blended with informed human oversight, which may resolve some of these issues. In addition, harvesting multiple streams of information, and allowing the machine to learn which ones are relevant, may allow for more real-time understanding and responses to ESG issues. Calculating Relative ESG Performance In a constantly evolving landscape, there is still a plethora of different ESG ratings firms trying to more accurately quantify ESG performance (although consolidation has started to happen). ESG ratings grade companies against given ESG standards, evaluating their performance on a sustainability scale. By collating disparate data from annual reports, investment analytics, management data, and media coverage, and allowing for the companies’ perceived exposure to ESG risks, an alphanumeric (some ratings agencies use letters and others use numbers) score is generated as a representation of ESG performance. Unfortunately, no “golden copy” (an official, master version of a record) categorically states the ESG rating for a given company, with the ratings from different ESG scores not even correlating very well with each other. Currently, all ratings are subjective and hostage to the varying methodologies used by different providers, and they vary in consistency between sectors, regions, and the size of the business being analyzed. While the notion of an ESG profile is valued and largely understood by many companies, the capacity to identify tangible results is generally missing. In turn, this exacerbates and challenges a company’s ability to report on their sustainability grades and investors’ capability to meaningfully measure the output. This is primarily driven by the range of topics that can be considered within an ESG score. No single definition incorporates every environmental, social, and governmental action and resultant impact on a given business. Furthermore, because this is a work in progress, companies are likely to miss reporting on topics that ESG agencies feel are important, and so there is a compounding of the traditional analyst measurement issues with financial statement data, which can also lead to some massaging of available numbers. Multiply this by sector and regional considerations for companies in certain industries, and the ESG liability calculation can become complicated. CHAPTER 14 Defining and Measuring ESG Performance and Reporting 255 Additionally, different stakeholders express diverse priorities with respect to the appropriate relevance of ‘E,’ ‘S,’ or ‘G’ components within the ESG bundle, which leads to different weighting requirements for each component: »» Shareholders may be focused on companies showing long-term profitability with high ESG ratings to imply reduced risks. »» Consumers want to ensure that they are using products and services that leave them with a clear conscience. »» Employees want to work for a company that is aligned with their values. Therefore, the shareholder is expecting the company to prioritize a reduction in carbon emissions to prevent substantial fines, the consumer expects a reduction in plastic packaging, and the employee wants greater diversity and inclusion in the workforce. The company then needs to determine what prioritization it gives to meeting those requirements when evaluating its overall corporate objectives and whether any impact on its ESG score is relevant. Moreover, how does an investor appreciate the weighting given to a specific component when the rating agency produces only an aggregated score for all three components? Also, many agencies don’t provide a full description of the methodology that they use to arrive at their scores, which makes proper performance attribution difficult. Therefore, enforcing a legal requirement for disclosure at the corporate level should make data easier to compare and contrast, but this approach needs the standards mentioned earlier to ensure it isn’t limited by inconsistencies. Near-time (close to real-time) data would greatly assist the process as well, allowing for a potential adjustment of ratings as corporate events occur; otherwise, companies could continue to maintain a given score until periodic updates are publicly available. Different sectors are subject to different ESG risks and opportunities, and the timeliness of reporting from such sectors may also differ. Given the size of the chips being placed on the sustainable investment table, investors must have accurate ways to evaluate ESG performance and recognize ESG risk to enlighten the investment process. Naturally, they are looking for corporations expected to produce positive financial performance in the long term due to their ESG-driven business models when creating their investment strategy. The following sections consider how ESG portfolios have performed relative to broader market benchmarks, such as the MSCI Europe, and more specific benchmarks, such as the S&P 500. 256 PART 3 Applying ESG Philosophy Against the broader market Research from data vendor Morningstar, in June 2020, confirmed that the majority of sustainable strategies, in a sample of 745 Europe-based sustainable funds, outperformed the non-ESG funds in the broader 4,900-fund universe over one, three, five, and ten-year time periods. Previously, there had been incomplete data on sustainable funds’ long-term performance due to the comparatively short track records of numerous strategies and significant variation in ESG approaches. Given that the exclusion of non-ESG compliant stocks has been the favored approach in Europe for ESG portfolios, it’s fair to say that such funds may have been more concentrated than a broader market universe; however, typically the number of stocks excluded from benchmark indexes is relatively small. Consequently, although the research doesn’t state it explicitly, this may have suited fundamentally managed active strategies, as such portfolios are usually more concentrated. Alternatively, for quantitatively managed passive strategies, any exclusions tend to reduce the power of the model by reducing diversification and thus expected performance. However, historical tests have shown that if the number of excluded stocks is small, the universe is still large enough to retain most or all of its exposure. When exploring the connection between sustainability and future investment returns, it has been conventional to consider the connection between a company’s present sustainability rating and its future investment returns. More recent research has studied the relationship between positive changes in a company’s sustainability rating and its future performance. Such research suggests that the best time to invest, for those looking to benefit from upgrades in companies’ ESG ratings, is prior to the development being broadly recognized and remunerated by the wider market. Of course, this raises the question “To what degree is this evidence already assimilated into stock prices?” If positive ESG ratings are already priced into highly rated stocks, an alternative strategy could be to buy the stocks with lower ESG ratings. This would mirror the general approach taken by private equity investment managers who don’t ordinarily look to acquire a stake in the best-run firms, but often focus on firms with, for example, operational problems, as they have a larger potential upside when restructured. Similarly, today’s ESG “dogs” could be the “rising stars” of tomorrow if they pivot and improve their ESG performance over time. Finally, ESG ratings seem to experience greater longevity than other investment factors, which has been confirmed by ESG funds and companies deemed suitable for inclusion in the broader asset allocation discussion and policy benchmarks. Traditional factors such as momentum characteristically persist for a few months at a time, whereas the impact of ESG ratings on systematic and characteristic risks CHAPTER 14 Defining and Measuring ESG Performance and Reporting 257 have lasted for several years, according to various studies. Perhaps this suggests that a momentum-driven ESG portfolio is something to consider. Against specific benchmarks Studies verifying positive performance from ESG- or sustainability-focused portfolios tend to highlight stocks with financially material factors. These studies show that investments in stocks with material ESG factors can produce positive returns for shareholders, whereas investing in immaterial ESG factors has little impact on returns. An example of material factors could be an airline looking to reduce their carbon emissions or to utilize renewable energy where possible. In comparison, an investment bank could aim for similar targets, but reducing their carbon emissions, while noble, would be immaterial, although their use of renewable energy for their offices could be material. Essentially, this would entail extracting the material ‘E’ rating from their overall ESG rating and applying that accordingly. Analysis of returns during the first half of 2020 show that many ESG-integrated index strategies have outperformed the broader market, such as returns from the S&P 500 Index. Studies have analyzed the performance of U.S. equity ESG indexes based on the S&P 500 Index, offered by different index providers, that have been created to reproduce broad risk-and-return characteristics while aiming for an enhanced ESG profile. While all of the ESG indexes outperformed the benchmark index, their portfolio construction entailed differences in performance where, for example, some indexes take on more active risk compared to other index strategies. This signifies that some indexes will outperform other indexes during periods when ESG strategies jointly do well; however, this degree of active exposure may not be suitable for all investors. These variances can also be explained by the different weightings given to individual stocks or sectors and the policy on exclusions adopted by each index provider. When analyzed further, it’s noticeable that this market outperformance can be largely attributed to the performance of given sector weightings in the ESG indexes compared to those in the S&P 500 Index. All of the ESG indexes showed that the sector that contributed most to relative outperformance was Information Technology (primarily the FAANG stocks — Facebook, Amazon, Apple, Netflix, and Google). Then, subject to the particular index construction approach, Industrials, Financials, and Consumer Discretionary also contributed to outperformance. However, despite suggestions to the contrary, the energy sector underweight position (due to exclusions) relative to the benchmark index, which is an anticipated theme in ESG index portfolio construction, didn’t contribute much added value to the outperformance. 258 PART 3 Applying ESG Philosophy While many ESG indexes based around benchmark indexes have very similar characteristics and component stocks, each index provider tends to employ factors that differentiate their methodology approach. This can include indexes that prioritize diversification, through a large number of securities with a smaller ESG focus, to those that give a greater weighting to “best-in-class” ESG stocks or sector weightings, or have different exclusion rules than others. Consequently, investors seeking indexes that provide given levels of exposure to ESG should observe any key methodology differences. You can find examples of different types of index exposure here: www.msci.com/documents/1296102/17835852/ MSCI-ESG-Indexes-Factsheet.pdf. It’s also worth noting the effect of demand-driven factors on performance. The growing recognition of ESG has led to a convergence of demand-driven factors, including the growth of passive ESG strategies, and the development of active approaches, which has driven “crowding” into some of the higher-rated ESG stocks while avoiding those with lower ESG ratings. Getting a Handle on Ratings and Rankings As frequently mentioned throughout this book, not all ESG rating agencies score the same companies’ ‘E,’ ‘S,’ and ‘G’ components equally. This is accurate for both agencies that create aggregated ESG ratings and those that generate more granular ratings to specific ‘E,’ ‘S,’ and ‘G’ levels. In large part, this issue is compounded by the contrastingly high level of correlations seen between credit rating agencies in their rating of corporate default probabilities. However, it’s clear that credit ratings have been in business for a much longer period of time, the data available is more timely and standardized, and the output is more closely aligned to financial statement information. Moreover, the determination of ESG risk factors that contribute to the probability of default are easier to determine than the combination of factors that might result in financial outperformance. Nor should we forget that sell-side research analysts typically have considerably different buy, hold, and sell recommendations, despite having access to identical, publicly available financial statement information. As discussed earlier in this chapter, this highlights the lack of standardization, which is changing with the imposition of mandatory requirements for ESG reporting in certain jurisdictions and industry-led initiatives to overcome these problems. However, these initiatives won’t answer all of the data problems and lead immediately to a solution on commonly agreed-upon inputs and outputs that everybody will adhere to automatically. The bottom line is that, as with the already more standardized stock and bond research, analysts will have different CHAPTER 14 Defining and Measuring ESG Performance and Reporting 259 perspectives on what relevance and weighting to apply to given companies on their ‘E,’ ‘S,’ and ‘G’ data. Opinions drive markets, and some analysts have access to different intelligence or more timely data than other analysts, which creates a market. So, you have to accept that this is still a work in progress for the time being. The following sections consider how ESG factors can be integrated into securities and portfolio analysis and where smart beta strategies can be incorporated alongside either of these approaches. Securities When ESG factors are incorporated into securities analysis, they are analyzed together with other valuation criteria. Historically it was common to integrate ESG factors using qualitative analysis; however, investors are progressively measuring and incorporating ESG factors into financial forecasting and company valuation models, in conjunction with other financial factors. Forecasted company financials influence valuation models, such as the discounted cash flow (DCF) model, which ultimately drives the estimated value (or fair value) of a company. Investors tend to adjust forecasted financials such as operating cost, revenue, and capital expenditure for the anticipated impact of ESG factors. Given that future revenues and growth rates have a substantial impact on the fair value of a company, investors will usually guesstimate the industry growth and how much market share a specific company may gain or lose. ESG factors can be incorporated into these forecasts by amending the company’s sales growth rate by a quantity that indicates the level of ESG opportunities or risks. Investors will also make assumptions about the effect of ESG factors on future operating costs and the resulting operating profit margin. The valuation models that investors use to value a firm can then be adjusted to reflect ESG factors. Some models entail calculating a terminal value for a company (the anticipated value of the company at a point in the future, assuming the company generates a given level of cash flow forever), which is discounted back to the current day. A positive terminal value should increase a company’s fair value; however, ESG factors might cause investors to assume that a company won’t exist indefinitely. There are a lot of discussions around the possibility that given fossil fuel companies, such as coal mining, oil, and gas companies, may see their assets stranded (prior to the end of their economic life, no longer able to earn an economic return as a result of changes associ

ESG Investing For Dummies: Defining and Measuring ESG Performance (2021)

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