ABC of ESG INVESTING

ABC of ESG INVESTING

With more than US$38 trillion in global sustainable AUM (Bloomberg Intelligence, 2021), understanding how ESG issues impact the investment decision-making and investment management industry is increasingly vital for all investors.

Apakah itu ESG?

The original use of the term ESG can be traced back to when the then-United Nations Secretary-General Kofi Annan invited leaders of financial institutions, institutional investors, asset managers, global consultants, government bodies and regulators to participate in an international conference, jointly hosted by the Government of Switzerland, UN Global Compact and International Finance Corporation, to integrate ESG into capital markets which resulted in a study entitled “Who Cares Wins: Investing for Long-Term Value” (2005). The study sets out the business case for embedding ESG issues into investment decisions, thereby improving the sustainability of financial markets and leading to a better outcome for society.

In a nutshell, ESG criteria are a set of metrics to assess a company’s operations by socially conscious investors to screen potential investments based on corporate policy, and to also encourage investee companies to be good corporate citizens. The ESG criteria metrics help investors to evaluate any ESG risks a company might face and how the company is managing those risks. ESG can be defined as follows:

The Environment (E) pillar considers impacts of a company’s operations on the environment and includes climate change, carbon footprint, GHG emissions, water resource depletion, waste and pollution, biodiversity, deforestation, energy efficiency and renewable energy.

The Social (S) pillar looks at a company’s abilities to deal with social trends, labour and politics, including working conditions and labour standards, slavery and child labour, local and indigenous communities, human rights, gender, diversity, equality, inclusion, employee relations, health and safety, data protection and privacy, customer satisfaction and fair-trade practices.

The Governance (G) pillar considers how a company is run, taking into account factors such as corporate governance and transparency, including board composition and structure, executive compensation, bribery and corruption, lobbying and political donations, whistle blowing schemes, internal controls, risk management, corporate culture and corporate strategy.
 

The growing demand for ESG investing
 

The growing investor interest in ESG issues reflects the view that ESG risks and opportunities can affect the long-term performance of corporates and should therefore be given appropriate consideration in investment decisions. This opinion is supported by a recent Natixis “Institutional Investors Outlook 2022” study that found more than 75% of institutional investors believe that ESG is integral to sound investing. Moreover, global sustainable assets are expected to grow to US$53 trillion by 2025, a third of total global AUM (Bloomberg Intelligence, 2021). Investors consider ESG issues for various reasons. Some may see them solely as economic risks and opportunities; a source of economic value. On the other hand, others may see ESG issues not just as risks and opportunities, but also as a matter of moral values.

To meet the ESG investing objectives, global sustainable fund management firms have integrated ESG considerations into their investment processes, such as, screening, security valuation, portfolio management, thematic and impact investing approaches. For instance, BlackRock, the world’s leading investment, advisory and risk management solutions with AUM of US$8.5 trillion (Statista, 2022) have integrated ESG into their investment processes since 2016. Generally, ESG investing use one or more methods to incorporate ESG criteria across asset classes with a long-term investment perspective. There are mainly six methods used in ESG investing (CFA Institute, 2019), which includes:

  • Exclusionary or negative screening is the avoidance of certain securities based on traditional moral values, for example, alcohol, tobacco or gambling products or services, and on the basis of standards or norms, such as, human rights and environmental protection.
  • Best-in-class selection is the preference of companies with better or improving ESG performance relative to sector peers.
  • Active ownership refers to the practice of engaging with companies on ESG issues and exercising ownership rights and voice to effect change, such as, through voting in shareholders’ general meetings, writing letters to companies’ management, or issuing statements to the mass media.
  • Thematic investing is the practice to invest on specific trends based on social, industrial or demographics. ESG themed investments include those related to renewable energy, clean tech, green real estate, sustainable forestry, agriculture, education and healthcare.
  • Impact investing is the practice to invest with the intention to generate positive, measurable social and/or environmental impact alongside a financial return using evidence and available data to drive investment design through measuring and reporting of underlying investment performance (as defined by Global Impact Investing Network). Investors with credible impact investing practices often use shared industry terms, conventions and indicators.
  • ESG integration is the systematic and explicit inclusion of ESG risks and opportunities in investment analysis, without necessarily including peer group benchmarking of industry leaders or laggards nor any ex-ante criteria for inclusion or exclusion.
     

ESG investing: Challenges and Fallacies
 

Conceptually, detractors of ESG investing argue that ESG investing exclude assets based on moral values reduce the investible universe, assuming a higher risk exposure and expected to generate lower returns compared to conventional investing. However, there are a growing number of researches to prove otherwise. For instance, a study of 36 Malaysian public listed firms that have been consistently reporting ESG scores from 2015 to 2019 showed a positive relationship between sustainability and financial performance when measured using return on assets (ROA) and return on equity (ROE) (Thomas et al, 2021). Another study that examined 116 listed Swedish companies in 2019 found a positive correlation between corporate sustainability practices and financial performance as measured in terms of earnings yields, ROA, ROE and return on capital employed (Pham et al, 2021).

ESG investing often have received many criticisms, such as the prevalence of greenwashing, which is the practice of creating a false impression or marketing and communicating misleading information that a product is more environmentally sound. For example, two financial institutions, BNY Mellon in the US and DWS, a subsidiary of Deutsche Bank in Germany, have been accused by their respective regulators of exaggerating their ESG credentials. BNY has been fined US$1.5m for the mis-statements and omissions by the US Securities Exchange Commission. DWS is facing similar enforcement action by German officials for selling investments that were “greener” or “more sustainable” than they actually were (ICAEW, 2022). This has raised concerns amongst global regulators. The European Commission’s Sustainable Finance Disclosure Regulation, effective from 1 January 2023, is designed to prevent greenwashing by requiring the finance sector to report on the impact of their company, products and services have on ESG. Other jurisdictional regulators are expected to follow suit to address the greenwashing issue.

In the last decade, the mass media has highlighted a growing list of ESG-related corporate scandals that have damaged the reputation of these companies and the resultant losses suffered by stakeholders from falling corporate valuations. For instance, the manipulation of emissions tests by Volkswagen in the US. In this case, the US Environmental Protection Agency (EPA) found that in over 590,000 diesel vehicles, Volkswagen had violated the Clean Air Act as the vehicles were equipped with “defeat devices” in the form of a computer software, which was designed to cheat on federal emissions tests. Later, Volkswagen admitted similar devices were fitted in 11 million diesel vehicles worldwide. The regulatory breach cost the company US$33 billion in vehicle recalls and refits, and regulatory fines (Indian Express, 2020).

Another corporate scandal closer to home relates to the accusation of debt bondage of foreign workers, excessive overtime and abusive working and living conditions in two Malaysian units of Top Glove Corporation by the US Customs and Border Protection (CBP) (BBC, 2021). These human rights breaches were later rectified by the introduction of a recruitment fees repayment plan scheme, renewed pledges to eliminate recruitment fees, repayment of US$12.8 million in recruitment fees to 10,000 foreign workers and promised upgrade of workers’ housing (Los Angeles Times, 2020). Subsequently, the company have significantly resolved six of eleven forced labour International Labour Organization (ILO) indicators: abuse of vulnerability, restriction of movement, excessive overtime, abusive working and living conditions, isolation, and withholding wages, while the resolution of the remaining five forced labour indicators: retention of identity documents, deception, debt bondage, physical and sexual violence and intimidation, were still in progress (The Edge Markets, 2021). These corporate scandals were the impetus for more stringent and robust investment policies and screening processes that consequently accelerated the adoption of ESG investing practices within the investment fraternity, as evidenced by the significant increase in the number of Principles of Responsible Investment (PRI) signatories from 63 in 2006 to 3,826 in 2021 (PRI, 2022).

Additionally, ESG investing suffers from methodological inconsistencies, lack of evidence of risk-adjusted returns, questions over how ESG ratings align with climate transition and environmental objectives and lack of standardized ESG disclosures from ambiguous quality and availability of ESG data. Currently, the global standard setters are working to close these gaps with high quality, transparent, reliable and comparable reporting disclosure standards. Furthermore, innovative and technological breakthroughs are also expected in ESG investing strategies, ESG rating methodologies and risk-adjusted return predictive models to make ESG investing more attractive to investors.
 

ESG investing is here to stay
 

Increasing investor interest, a sharper corporate focus and a significant improvement in global reporting standards and regulatory frameworks, resulting quality ESG data provision, are all set to further support the growth in ESG investing. There remain obstacles to overcome—in terms of integration of ESG pillars and measuring positive impacts of ESG—but with new ways to capture sustainable returns and to measure impacts are being developed, and with many more companies committing themselves to sustainable business goals, it is easier than ever for investors to mitigate ESG risks in their portfolios while contributing to positive change of the financial markets.


References:
BBC News, “US to seize Top Glove products over labour abuses”, 31 March 2021
Bloomberg Intelligence, “ESG assets may hit $53Tn”, 2021
CFA Institute, “Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences “, 2019
European Commission Press Statement, “Screening of websites for greenwashing: half of green claims lack evidence”, 28 January 2021
Indian Express, “Explained: What is the ‘dieselgate scandal’ against Volkswagen?”, 27 May 2020
Institute of Chartered Accountants in England & Wales (ICAEW), “Greenwashing: The next mis-selling scandal?”, 4 July 2022
International Finance Corporation, World Bank Group, “Who Cares Wins 2005 Conference Report: Investing for Long-Term Value”, 2005
Los Angeles Times, “These gloves help fight Covid-19. But they’re made in sweatshop conditions”, 22 Sept 2020
Natixis Institutional Investor Outlook 2022
Pham, D C, Do, T N A, Doan, T N, Nguyen, T X H and Pham, T K Y, “The impact of sustainable practices on financial performance: evidence from Sweden”, Cogent Business & Management, 2021
Principles of Responsible Investment (PRI), “PRI Growth 2006-2021”, 2022
Statista, “Total Asset Under Management of BlackRock from 2008 to 2Q2022”, 6 Sept 2022
The Edge Markets, “Top Glove: Significant improvements achieved in resolving forced labour issues after engaging independent consultant, 8 April 2021
Thomas, C J, Tuyon, J, Matahir, H and Dixit, S, “The impact of sustainability practices on firm financial performance: evidence from Malaysia”, Management and Accounting Review, Volume 20 No 3, 1 December 2021

Details
Published Date
29 Dec 2022
Source
Bursa Malaysia
Proficiency Level
Beginner
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