Photo: ©Romolo Tavani: iStock
Environmental, Social and Governance (ESG) integration has become an increasingly important topic in the financial sector. It is an investment approach where the objective is to increase the financial returns of a portfolio with ESG performance as the means to achieve this. This investment approach has implications for investors and listed companies.
To offer transparency, more and more stock exchanges have been making ESG disclosure mandatory in recent years. In parallel, the reality of enhancing investment strategies using ESG factors and leading to better performance over the long-term is making headway with mainstream investors.
Why is ESG performance important to investors?
There is strong economic rationale explaining how strong ESG performance translates to good financial performance. In short, strong ESG performance means a company:
- Considers its environmental footprint (the use of natural resources, contribution to climate change and pollution control) and is proactive in implementing initiatives to address this
- Addresses the social concerns within the communities in which they operate in and along its supply chain
- Views its human capital as a valuable resource that is worthy of investing in
- Has risk control and compliance standards across the company and within its supply chain
- Has a strong and transparent corporate governance structure in place
As a result, companies with ESG strategies in place are more efficient at using resources, retain human capital and incubate innovation. Essentially, they are better managed companies and are typically better at developing long-term business plans that take into consideration external ESG-related risks (i.e. modern-day slavery within its supply chain, climate change risks and corruption). These considerations make them better at managing risks and opportunities. In the eyes of investors, they are less vulnerable to systematic market shocks and therefore show lower risks. For instance, commodity- or energy-efficient companies are less vulnerable to changes in commodity or energy prices than less efficient companies and therefore their share price tends to show less systematic market risk with respect to these risk factors.
It’s not just about ESG performance, it’s about ESG performance over time – ESG Momentum.
Taking this a step further, some investors consider any absolute ESG score to be insufficient in providing a complete understanding of a company’s ESG behaviours and the consequences for risks and returns. Instead, they look for the change in ESG performance over time – ESG Momentum – as an indicator for financial performance. The approach views stocks that demonstrate improving ESG ratings as higher performing than those with deteriorating ratings. These investors care less about the overall ESG score and more about the direction of the company. The effectiveness applying ESG Momentum to yield higher financial returns has seen support from MSCI’s research where ESG Momentum yielded an excess return of 2.2 percent annually over the MSCI World Index from February 2007 through March 2015.
To date, debates amongst the financial industry continue on how to assess, measure and monitor ESG performance of companies, so that investors can accurately valuate them. Nonetheless, is it safe to assume that despite the assessment method, companies are expected to report their ESG performance in one way or another and that investors will consider these results when making investment decisions.
To learn more about how investors’ interest in ESG performance is shaping the way companies operate, join us at the Sustainable Finance breakout session at the CSR Asia Summit this September in Hong Kong.
Companies with strong ESG credentials make better investments by Financial Times
ESG & Corporate Financial Performance: Mappin the global landscape by Deutsche Asset Management