At A Glance
Sustainable behaviours in the banking and financial industries are crucial for long term development, keeping warming below 1.5°C and achieving the United Nation’s 2030 Sustainable Development Goals. According to the World Economic Forum, the sustainable finance market is estimated to be worth over $380 billion annually which highlights the need for attention. With calls from Larry Fink, CEO of Blackrock, urging investors to integrate climate risks into their portfolio analysis it is increasingly important. Financial expert Robert Eccles in an article for Harvard Business Review argues we are experiencing an investor revolution where long term financial dividends are focusing on ESG risks and opportunities.
The rise of socially responsible investing is accompanied by ESG analysis which is explored in the S & S Decoded below.
It is clear the upsurge in sustainable investing demonstrates that those working in financial industries want to align their values through their investment decisions. Here are some statistics to contextualise the current landscape:
- Nearly 60% of investment firm board members say they are willing to divest from companies that have poor sustainability performance. MIT Sloan Management Review Research Report 2016
- The number of institutional investors committed to cutting fossil fuel stocks from their portfolios has increased dramatically up from 180 in 2014 to more than 1,100 in 2019. Financial Times
- In 2018, approximately $58.8 billion in social and sustainability bonds were issued. As of October 2019, the green bond market alone surpassed $200 billion in total issuance. Reuters
- Investments worth more than $20 trillion could be left stranded as governments set more ambitious climate targets. Bank of England
What is ESG?
Socially responsible investing is a long-term investment strategy to assess businesses and institutions and combines financial analysis with ESG factors that create value for investors and society.
Environmental, social and governance (ESG) criteria are a set of standards within a company’s operations that socially conscious investors use to screen their potential investments. Broken down, they pay attention in particular to:
Environmental – critically analyses a company’s impact on the planet, this can be emissions, energy use, waste, pollution, impact on natural resources/eco systems or animal treatment.
Social – examines how an organisation looks after its employees. It extends to the company’s stakeholder network, this could be suppliers, customers, NGO’s, and local communities. It pays attention to supplier integrity along the value chain, charitable endeavours including volunteering as well as health and safety.
Governance – scrutinises the leadership practices within the firm. By evaluating executive pay, audits, internal controls, transparency, history of corruption and political contributions it helps investors gain a clearer moral picture.
Who Uses ESG?
Many funds, broking firms and advisors offer products that utilise ESG criteria in their decision making. Investors call upon ESG analysis to avoid companies that may be a greater risk within their portfolio, in part they use negative screening which you can read more about here.
Leading financial services companies such as JPMorgan Chase, Wells Fargo and Goldman Sachs review their approach to ESG in their annual reports which signals a step in the right direction and should encourage firms. Furthering this, a recent study by Harvard Business Review of 70 senior executives at 43 global institutional investing firms including BlackRock and Vanguard illustrated that ESG was a paramount priority.
For each individual company and investor, their priorities vary on which factor is more important.
All can be guided by institutional frameworks. For example, ESG is recognised by various criteria including the Dow Jones Sustainability Index, CDP Insight Action Programme and Transparency International.
Additionally, the UN Principles for Responsible Investment, signed by over 1700 organisations, is shaping the global narrative. They have created a tool that companies can use to assess and communicate the financial impact of their sustainability strategies.
Collaboration amongst the industry has also seen the launch of the Principles for Responsible Banking. Established in Autumn 2019, 130 global banks with over $47 trillion in collective assets will follow thisframework which works to accelerate the banking industry’s contribution to achieving the Sustainable Development Goals and the Paris Climate Agreement.
Furthering this, the Sustainability Accounting Standards Board have largely assisted in devising industry standards that demonstrate a clear link between impact and economic performance to encourage participation.
How Does ESG Help Sustainable Development?
This form of portfolio screening identifies the correlation between economic returns and a positive social and environmental impact. Traditional management practices that focus purely on the bottom-line profits do not support sustainable development, nor do they account for all risks. Such risks include extreme weather events created by climate change or the destruction of intangible assets (brand reputation/customer trust), for example the BP Oil Spill of 2010. This pulls into play John Elkington’s triple bottom line approach which looks at reporting on people, planet and profits.
As we enter the climate decade – the next ten years are critical to ensure we do not tip our planet beyond irreversible damage. According to the Global Commission on the Economy and Climate, an investment of some $90 trillion is needed over the next 15 years to achieve global sustainable development and climate objectives. ESG portfolio screening will prove to be a crucial instrument in this for the financial industry.
For me, adoption of ESG analysis demonstrates a truly throughout approach to risk mitigation. Leading academics in the field, Michael E Porter, Mark Kramer and George Serafeim note that:
“When investors ignore their own social responsibility and fail to recognize the powerful connection between company strategy, social purpose, and economic value, they are eroding the impact and legitimacy of capitalism as a vehicle for advancing society.”
You can read their article ‘Where ESG fails’ here.
What are the Limitations of ESG?
It is worth noting ESG criteria is not always the first phase of risk assessment of potential investments. Instead some financiers choose to narrow down their options through financial analysis and then further sift through a company’s ESG performance.
There is the limitation that if analysts do not interpret a company’s ESG scorecards correctly, they will be liable to increased risk for not understanding the full picture. For example, if they only have the emissions of a large corporation but none of their outsourced third-party suppliers, it could mis convey the true rating of the company. For those that aren’t aware, ESG scorecards measure the three attributes of the portfolio analysis through reports and audits published by the company.
The Future for ESG
There is no doubt that ESG portfolio screening will experience a broad uptake by the financial industries as we ebb closer to 2030 and the need to meet the Paris Agreement. Asset managers will become increasing familiar with interpreting the risks and opportunities displayed through these metrics. They will become increasingly critical on the quality and trustworthiness of data presented by companies. Therefore, those seeking investment must demonstrate their commitment to long term sustainable performance in all three areas. This includes increased disclosure on areas where they may fall short such as fourth/fifth tiers of supply chains or executive pay.
In an increasingly value driven society, individual companies should align their beliefs to their own investments. For example, if the organisation has committed to net zero targets, all pension investments should actively be divested from carbon heavy stocks.
Integrating ESG performance indicators into investment models is the crux of aiding sustainable development in the financial space. It holds global organisations to account on more than simply their bottom-line performance and elevates the fundamental importance of environmental and societal value. With international institutions and sustainable frameworks now established, it encourages a collaborative approach between banks and investment firms, which is vital for corporate social responsibility. By adopting a more holistic approach to organisational performance it will further sustainable development as managers will increasingly consider circularity, innovation, natural capitalism and eco effectiveness.