ESG is the latest concept on everybody’s lips in the financial sector today – whether it is the world’s largest investment firm, Blackrock, calling on companies to explain their social purpose, the biggest sovereign wealth fund, Norway’s Government Pension Fund, pondering whether to divest from fossil fuel companies or Calpers, one of the largest US pension funds, looking at how it can incorporate the Sustainable Development Goals into its investment processes. Environmental, social and governance issues are now taking centre stage.
It used to be very different. The first investors to take ESG issues into account – also known as ethical or socially responsible investors – were more interested in investing in accordance with their values than in generating value. As a result, such issues were very much a niche concern and the ethical investment market was, and remains, a small proportion of the overall market. However, that has all changed now.
ESG - A passing trend or here to stay?
“ESG is now completely mainstream for asset owners,” said Florence Fontan, global head of asset owners at BNP Paribas Securities Services. “If you want to win a mandate and be a credible partner to asset owners, you have to demonstrate that you take ESG seriously and that you can help them to take the right decisions.”
The importance of ESG is expected to grow rapidly in years to come. The BNP Paribas Securities Services survey in 2017 found that asset managers and owners planned to double their investments in ESG-driven strategies over the next two years.
The report, ‘Great Expectations: ESG – What’s next for asset owners and managers’, states that 79% of respondents incorporated ESG either in how they invest as asset owners, or in terms of the products they market, as asset managers. Many of those that currently invested 25% or less of assets in ESG strategies were planning to lift this share to more than half of assets by 2019.
Is this just a passing trend, or are ESG issues now set to become permanently embedded in investment strategies? It looks like they are here to stay, for a number of reasons.
Firstly, there is a growing realisation that without taking ESG into account, investors do not have a full understanding of the risks and opportunities that are faced by the companies that they invest in. It is increasingly clear that issues such as climate change, resource availability, labour conditions in supply chains and bribery and corruption can have significant impacts on company revenues and therefore investors’ returns.
“ESG enhances your understanding of a company as an investor and gives a more holistic view of a business"
Trevor Allen, a client development manager at BNP Paribas
ESG and returns
After many years where the industry believed that taking ESG issues into consideration would lead to lower returns, there is now a growing body of research suggesting that the exact opposite is true. For example, a 2017 study by Boston Consulting Group found that “companies that outperform in industry-relevant ESG areas boast higher valuation multiples and margins, all other factors being equal, than those with weaker performance”.
Oil and gas companies that deal well with issues such as corruption, health and safety, and environmental damage have a valuation premium 19% higher than the median performers, the group said.
Meanwhile, index provider MSCI published research that explains the effect of ESG on equity valuation, risk and performance. The report found that companies strongly rated on ESG issues are better managed and more adept at dealing with risks and opportunities. “High ESG-rated companies tended to show higher profitability, higher dividend yield and lower idiosyncratic tail risks,” Guido Giese, executive director, Applied Equity Research and one of the report’s authors, said. “We also found that high ESG-rated companies tended to show less systematic volatility, lower values for beta and higher valuations.”
79% incorporate ESG in how they invest or in terms of the products they market
Source: BNP Paribas Securities Services ‘Great Expectations’ report
The increase in the importance of ESG issues has been driven partly by an increase in regulation and other initiatives to tackle issues such as climate change, in particular the Paris Agreement. It has been helped by technological advances such as big data and artificial intelligence and encouraged by the rise of passive investing. Investors that cannot sell out of companies because they are universal owners need to know what issues might affect their returns, so they can engage with management to reduce risks and improve performance.
However, there are still big gaps in the amount and quality of ESG data available to allow investors to assess company performance. And the data that is available is often not sufficiently standardised to allow one company to be compared with another. The BNP survey found that 55% of respondents think that a lack of robust data was a barrier to further ESG adoption.
“In the past two years humankind has created twice the amount of data that ever existed before. But we know that a lot of the data that is available today relates to companies in the Western, developed markets,” said Allen. “It’s not just about the amount of data that is available. A lot of work needs to be done on standardising methodologies as well.”
More data becomes available every day and the ability to make sense of it is growing exponentially, as computing power and analytical technologies advance. A focus on ESG data alone is not enough to make a business successful. “A company can be very ESG-focused, but if the business model is not sustainable, it will still fall apart,” he added.
However, ESG can be a powerful part of a company’s business model, said Jean-Philippe Hecquet, Investment Risk and Performance specialist at BNP Paribas. “There has been a transition from a focus on risk management to looking at the opportunities ESG creates.”
These opportunities include moving away from risky business lines, creating new products and opening up new markets. But perhaps most importantly, having good visibility on ESG risks helps companies to future-proof their operations from some of the most severe impacts of factors such as climate change, water shortages and poor working conditions – both in terms of the physical impacts on the ground and measures that could be imposed by governments and regulators to tackle the problems.
As companies get to grips with these issues at an operational level, investors need to aggregate these ESG advantages to the portfolio level to ensure they are ready for the challenges and the opportunities of tomorrow’s markets.