Over the last decade, public awareness of issues such as social inequality, climate change and corporate malfeasance has pushed responsible investing to the forefront of advisory discussions with clients. Asset managers are now looking to incorporate environmental, social and governance (ESG) considerations into their investment process — as a driver of investment risk and, hence, return.
ESG assets have grown in popularity significantly and are currently on track to exceed $50 trillion by 2025, representing more than a third of the projected $140.5 trillion in total global assets under management, according to Bloomberg Intelligence’s latest ESG 2021 Midyear Outlook report. This is demonstrated further in the growing number of signatories to the UN Principles for Responsible Investment. These signatories represented more than $80 trillion in 2018, equal to the assets managed by the global asset management industry, compared with approximately $12 trillion in assets 10 years earlier.1
The practice of responsible investing (RI) first emerged in the 1960s and needs to be distinguished from ethical, norms-driven investing, an investment philosophy dating to the 1800s. This approach — guided by moral values, ethical codes or religious beliefs — excluded investing in sectors such as slavery-derived goods, firearms, pornography, tobacco and alcohol.2 RI has been called many things over the last few years — green investing, ethical investing, etc. — but today, ESG investing is the most commonly used term. It refers to the measurement of an investment opportunity’s sustainability from the perspective of environmental, social and governance issues.
ESG issues are often interlinked and can be classified under more than one heading. Generally, anything related to climate change or the environment falls under “E”; health, safety and labour issues fall under “S”; and topics related to corporate board structure or shareholder rights fall under “G.”
Investments in sustainable funds more than doubled in 2020 compared to 2019, reaching a record-high $51 billion,3 according to Morningstar, with most fund flows going towards exchange-traded funds (ETFs). Since 2015, we have seen global ESG ETFs increase from $6 billion to over in $150 billion in AUM, an increase of 25 times.4 Despite the massive growth, ESG ETFs still represent only about 5% of the entire ETF universe. However, the projected future capital flows to these funds shows that ESG investing is not a fad and will have an impact on how investments are perceived going forward.
While there are many factors that have contributed to the overall societal growth in ESG awareness, there are three main drivers of capital flow to ESG investments:
The global regulatory environment is changing quickly, with many countries adding ESG requirements to their regulations. The European Union, for example, published its Sustainable Finance Disclosure Regulation in March 2021, which introduced definitions and minimum requirements for investments with ranging environmental and social objectives. This regulation builds on the Task Force on Climate-related Financial Disclosures (TCFD), developed to provide a framework for companies, asset managers and asset owners to increase transparency of systemic risks including climate change. Governments and regulators around the world are adopting the TCFD recommendations with the objective of improving climate governance and reporting for companies and their investors.5 Moreover, both governments and companies have pledged to achieve net-zero emissions of greenhouse gases by 2050 at the latest. Such a development would entail an economic transformation that would affect all countries and industries.
While climate change has garnered the majority of attention to date, other issues associated with the “S” and “G” buckets are gaining momentum. In 2017, the EU adopted the Shareholder Rights Directive II which sets out to better strengthen the position of shareholders and ensure that decisions are made to promote the long-term stability of a company while increasing shareholder engagement and improving corporate governance and transparency.6
In Canada, amendments to the Canadian Business Corporation Act (CBCA) now require that directors and officers of CBCA corporations not only consider the interests of shareholders, but all stakeholders when acting. The amendment also allows pension plan boards to incorporate ESG criteria into pension plan investments.
With progress being made along several fronts, such as climate change, MeToo, Black Lives Matter and other societal movements, individuals have never been more focused on social inequality, environmental crisis and inadequate governance. This has placed a sustained pressure on companies to ensure that they act in the interest of society at large. In 1970, economist Milton Friedman popularized a concept called the Shareholder Wealth Maximization theory. It argued that a company’s shareholders are the primary group to which the company is responsible and therefore, it is the firm’s duty to maximize shareholder returns.
In recent years, this theory has been challenged, recognizing the role firms play in broader society and the quid pro quo benefit firms receive by having effective and responsible relationships with both their employees and communities in which they operate. This aligns with Stakeholder Theory, which argues that a firm should create long-term sustainable value for all stakeholders and not just profits for shareholders. It emphasizes the interconnected relationships between businesses and its customers, suppliers, investors and even society.7 As such, the sustainability of a firm as viewed from a broader ESG lens is of significant importance in today’s markets, as related issues are now being recognized widely as key drivers of long-term value maximization.
Research suggests that firms which incorporate a strong ESG culture in the management of their business can enhance investment returns by allocating capital to more sustainable opportunities (renewables, waste reduction, etc.).8 Furthermore, it can help firms avoid investments that may not be beneficial economically in the long run due to environmental concerns. It is anticipated that new regulations enacted on carbon intensive industries will likely introduce new constraints on existing and future lines of business. For this reason, firms are repurposing assets today, to get ahead of the curve.
Strong corporate governance is widely recognized as a risk-mitigation tool that is in the best interest of all stakeholders. Strong governance promotes accountability and long-term focus by providing transparency and a clear link between robust value creation and compensation. Regarding social risks, companies that offer safer working conditions and better compensation can attract and retain superior talent and often achieve better productivity from their workers. Moreover, firms that are environmentally conscious not only attract more capital, but also reduce the risk of property damage from their operations and litigations that may arise from environmental damage. These are just a few examples of how ESG considerations can reduce risk while potentially adding value to a firm and therefore, shareholders as well.
Companies with a strong ESG focus understand the relationship between business, its stakeholders and society at large. Moreover, creating long-term sustainable value should be part of their core purpose while being transparent in their reporting of their ESG performance.
Sustainable investment drivers
Incorporating ESG into your personal portfolio begins by defining your values and beliefs, which can then inform your investment policy statement. Implementation decisions require alignment between your objectives (Are they broad based, or do you have targeted interests, such as “clean tech”?) and specific approaches adopted from the various investment managers. There are typically four approaches that investment managers employ to incorporate ESG into their process:
ESG integration and stewardship approaches are considered more active relative screening approaches that are more passive. Active ownership is an important component of sustainable investing as it promotes engagement with company management in a proactive and cooperative manner to achieve ESG objectives. Engagement is viewed as a more effective method as it broadens the universe of investment options by recognizing firms that are making progress on ESG initiatives rather than simply divesting away from companies that are not performing well on this front. Passive approaches aim to replicate an index or use an algorithm to select securities, which is less effective than engagement in advancing ESG performance at the company level.
A review of the ESG Global ETF universe reveals that the screening approach (the simplest) represents 44% of available options, while the integration approach — whereby managers seek best-in-class companies — makes up roughly 41% (a good balance between active and passive approaches). However, when considering asset size, the 24 largest US-based equity ETFs adopt the integration approach and collectively represent $25 billion. Only 3% of ESG ETFs follow an impact approach — focusing on investments that provide solutions to ESG issues — which in part is reflective of the complexity and resources necessary to pursue this route. In recent years, however, investment products have started to isolate universes of public securities linked to positive impacts with explicit references to applicable United Nations Sustainable Development Goals — the 17 goals listed by the United Nations with the intention of promoting prosperity while protecting the planet.
As of Dec. 31, 2020
Source: MSCI LLC ESG Research (Feb. 2021)
Today, ESG performance is becoming more measurable, allowing agencies to better assess the sustainability of companies and provide an ESG rating. That rating measures a company’s exposure to ESG issues and serves as a complement to financial analysis. A stronger ESG rating means a company is managing its ESG risk more effectively, relative to its peers. Conversely, a poor ESG rating simply means that a company has a high, unmanaged exposure to ESG risks relative to its peers. The most widely referenced ESG rating system is the MSCI ESG score, which measures risk across 10 categories of environment, social and governance areas.
At Mercer, we have a team of ESG specialist researchers that work alongside our dedicated team of global investment manager researchers that provide an in-depth assessment on an investment manager’s capabilities. Our process rates managers on four criteria:
Based on these criteria, Mercer assigns a rating on a 1–4 scale (1 being the best and 4 being the worst).
Mercer’s ESG rating scale
Regarding rating agencies, it is important to understand that each may have its own focus, which can cause discrepancies in ratings for the same investment across providers. For example, one agency may have more emphasis on “E” issues, while another may be more focused on “S” aspects.
A typical and frequent question is whether ESG-investing compromises attain higher returns for the greater good. Research from the International Monetary Fund found no conclusive evidence that sustainable investing approaches underperform (or outperform) conventional investment approaches.
Another consideration that investors should incorporate into their investment selection decision is fees. According to a 2020 Morningstar US mutual fund fee study, the expense ratio for ESG funds (0.61%) was higher than traditional funds (0.41%) — often referred to as a “greenium.”10 That said, fees are only one consideration in the decision-making process, and the focus should be on value for fees rather than solely on the absolute fee level.
With the increasing popularity of sustainable investing, investment managers are capitalizing on that momentum but don’t always go far enough in their security selection process; this is referred to as “greenwashing.” The most common criticism of ESG investing is that no investment can be considered 100% sustainable. Tariq Fancy, the former CIO for sustainable investing at BlackRock once dismissed it as “marketing hype.” The issue with ESG investing is that there is no one set of regulations or definitions that make an investment “sustainable.” Investors need to understand that ESG ratings are a points system, and as long as companies rank high enough, they can be ESG approved. For example, an oil company that recently made their board of directors more diverse and compensated employees better, could score a high enough ranking to be placed in an ESG fund that follows an index or uses a negative screening approach. Thankfully some investment managers favour active management that incorporates ESG integration and stewardship approaches. It is also worth noting that in some cases, the “fossil fuel” producers can also be part of the long-term solution if they are working towards incorporating more sustainable business practices, like investing in new technologies such as carbon capture and storage to remove carbon dioxide.
Companies have also attempted to increase their ESG rating and their ability to sell ESG bonds or equity by making commitments to be carbon neutral at some future date. We caution investors on this point, as essentially it provides funding to a firm with unsustainable operations that promises to clean up later. Some public companies offload their less sustainable business lines to the private sector in an attempt to appear more ESG sensitive. From a corporate perspective, they may be doing the right thing but this does not immediately make any significant difference to the common good as there is much less oversight in the private sector. This further emphasizes the point that divestment does relatively little by itself; it is engagement and making specific changes to business lines that will have a more lasting impact.
In order to minimize instances of greenwashing, regulators are further scrutinizing these business practices. Earlier this year, the Canadian Securities Administrators published their guidance for investment funds in the hope of ensuring that sales communications for ESG-related funds are not misleading.
Currently, investors have to do some of their own due diligence to determine the sustainability of their investments — a challenge for even the most sophisticated investor. If ESG investing is important to you, we suggest looking into a fund’s prospectus, which would explain its investment objectives and more importantly, its approach to sustainable investment. If an asset manager’s approach to ESG investing is detailed and disclosed, it is less likely to be a marketing ploy.
For individual companies, look at their reporting over time. Has the company followed through on their commitments in prior periods? Has the executive team been involved in the decision-making around ESG issues? Lastly, ESG investing is not intended to be an overnight fix to the world’s issues. It is part of a process working towards incorporating ESG considerations into investment decisions to promote long-term sustainability.
Investors are more passionate than ever about wanting their investments to make a difference. Labelling something as “ESG” without merit does not sit well with investors. Investors are demanding more insight into how companies and funds perform with regards to ESG issues. We expect these to remain top of mind in 2022 and beyond, and to see more convergence in related regulations and standards globally.
The US Securities and Exchange Commission is already expected to increase guidance on corporate disclosures, such as carbon emissions. Agencies around the world will likely encourage a common code of conduct for ESG ratings and make clear what these ratings capture. New technologies will continue to change the way we collect and store data, as well as improve real-time analysis on ESG ratings of funds, all of which will help investors make better informed decisions.
We hope this article continues to foster investor interest in obtaining healthy returns while also doing their part in making our world a little better.
1 Mercer. "The ABC of ESG." March, 2021. Accessed March 26, 2022.
3 Hale, Jon. "A Broken Record: Flows for U.S. Sustainable Funds Again Reach New Heights." Morningstar. January 28, 2021 Accessed March 28, 2022. www.morningstar.com/articles/1019195/a-broken-record-flows-for-us-sustainable-funds-again-reach-new-heights.
4 Neufeld, Dorothy. "Visual Capitalist." Visualizing the Sustainable ETF Universe. May 19, 2021. Accessed March 29, 2022. www.visualcapitalist.com/visualizing-the-sustainable-etf-universe/.
5 Mercer. 2021. From Acronym to Action — What ESG Means to You.
7 Mercer. 2020. "The Purpose of Corporation - A Tale of Two Theories." Mercer. Accessed March 27, 2022. https://www.mercer.com/content/dam/mercer/attachments/private/gl-2020-the-purpose-of-corporations-a-tale-of-two-theories.pdf.
8 Henisz, Witold, Tim Koller, and Robin Nuttall. "Five ways that ESG creates value ." McKinsey. November, 2019. Accessed March 25, 2022. https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx
9 Neufeld, Dorothy. “Visualizing the Sustainable ETF Universe.” Visual Capitalist. May 19, 2021. Accessed March 29, 2022. www.visualcapitalist.com/visualizing-the-sustainable-etf-universe/
10 Johnson, Ben. “2020 US Fund Fee Study.” MorningStar. August, 2021. Accessed March 25, 2022. https://assets.contentstack.io/v3/assets/blt4eb669caa7dc65b2/blt0b2eed63bfb1eb8b/619f8bf6224a1b121d540f7e/annual-us-fund-fee-study-updated.pdf
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