Integration of ‘ESG’ Factors in Investment Decision Making

The integration of extra financial factors in investment decision-making is no longer viewed within mainstream investment as a ‘soft’ or purely ethical issue. Environmental, social and governance practices are now defined in terms of financial risk and long-term sustainable performance.

Multifold initiatives recently evolved into concrete regulatory outcomes and in our view, this will mark a milestone in the evolution of the area. Whilst perhaps so far, the most regulation-prolific market in this area has been Europe, the regulatory momentum is by no means confined to that region (for example, market scale initiatives are also underway in Canada and Australia). Going forward, we believe that ‘ESG integration’ will be a fact of life in mainstream investment featuring a growing compliance-based dimension.

From the perspective of issuers, this means that articulating their ESG performance case to their investors will become an ongoing need. In other words, demonstrating base-level ESG performance will become almost a threshold requirement for investment by large mainstream international investors.

Several weeks ago, the European Commission took a significant step in its action plan for financing sustainable growth. The plan is a follow up on the recommendations of the High-Level Expert Group (HLEG) on Sustainable Finance, which were submitted to the Commission in January last year.

The action plan is ambitious in its breadth, outlining ten reforms in three areas. The implementation of several elements could each, and certainly overall, herald significant changes. For example, there will be an EU established classification system for sustainability activities. Standards and labels will be issued for green financial products. The recommendations contained in the plan span the breadth of many sustainability areas, and the full length of the investment chain. Thus, ratings and research firms will be required to integrate ESG and so will investment advisers. Finally, at the corporate level, sustainability disclosure and sustainability accounting rule-making will be encouraged, as will corporate governance measures to attenuate short-termism in capital markets.

Whilst the immediate impact of this bundle of measures will be felt in Europe, we believe that it is unlikely that some changes will not ripple out more broadly. The investment industry is an international one. Some of Europe’s largest investors are regional arms of groups headquartered in the US for example. Equally for corporates outside of Europe, European investors may represent a substantial proportion of their shareholder base so any broadening of their stewardship activity will again have a cross-border impact. Finally, the inclusion of intermediaries and of other players, benchmark providers notably, is likely to impact issuers and investors outside Europe.

In our view, surprisingly perhaps, these developments represent an exciting opening for those forward-looking companies who see the value of engaging regularly with their investors.

It takes the rationale of engagement from the ballot and extends it to ‘buy and sell’ decisions. Demonstrating to investors leading ESG performance, whether by reference to a market or to an industry, may well result in the company being more attractive to genuine long-term investors. It could make it easier for those investors to hold the stock and perhaps even unlock access to funds not otherwise available to ESG ‘laggards’. Finally, it would have the benefit to companies of moving the discussion from mitigating ESG risks to demonstrating how they are seeking positive impact or ESG upside.

What is yet to be determined is whether the continued integration of ESG assessments into investment disciplines is a near-term phenomenon or a long-term commitment – we may not know the answer to this question until ESG ‘best performers’ are shown to sustainably outperform those that are not.

Furthermore, ESG performance does not, at least at the present level of maturity, lends itself to standardisation of approach, whether with respect to reporting or even some basic question of measurement of performance. It means that the value of engagement is greater, as it offers companies the opportunity to clarify context and share their way of thinking. This will continue to remain the case for some time, even – and perhaps more so – as regulation evolves.