Value meets values

Category: Asia, Global
By Paul Smith*

The rise of ESG in investing

Global investors are increasingly scrutinising evolving environmental, social and governance (ESG) practices to assist in driving investment decisions. This emerging additional lens of analysis for determining investment value is growing in importance in Asia Pacific. As corporate stakeholders, regulators and the broader investment community in the region place a greater emphasis on ESG matters, it is providing the catalyst for wider application and significance to investment decisions.

ESG coalesces different areas of concern into a single concept that appeals to both value- and values-driven investors. Disclosure of ESG information can provide a holistic view of a company’s sustainability. The ESG issues reported span a broad breadth of topics including green financing, social responsibility, human capital, workplace diversity, executive compensation, and corporate governance. A key by-product of greater ESG disclosure will be enhanced transparency in investment decisions.

Utilisation of ESG information in the investment decision process appears to be a rising trend. In 2015, CFA Institute surveyed members to gauge their understanding of ESG issues, and how they integrate these issues into the investment process. Of members responding, 73% said that they actively take ESG issues into account during the investment analysis and decision-making process.

When asked how ESG issues were taken into consideration, 57% of survey respondents said they integrate ESG into the whole investment analysis and decision-making process, while 38% stated that they use best-in-class positive alignment, and 36% use ESG analysis for exclusionary screening. The main reasons survey respondents take ESG issues into consideration in their analysis are to help manage investment risks (63%), and because clients/investors demand it (44%).

Par for the course

At CFA Institute, ESG has been in the curriculum in various forms for nearly a decade. CFA Institute is constantly updating its ESG knowledge to ensure it and its members keep up with best industry practices.

Based on our studies, investors currently apply at least one of six main methods when considering ESG issues:

  1. Exclusionary screening: Avoiding companies or countries on the basis of traditional moral values, standards and norms.
  2. Best-in-class selection: Preference for companies with better or improving ESG performance relative to sector peers being implemented on either the level or change in ESG performance.
  3. Active ownership: Practice of entering into a dialogue with companies on ESG issues, and exercising both ownership rights and voice to effect change.
  4. Thematic investing: Investing strategy based on trends; such as social, industrial, and demographic.
  5. Impact investing: Investing with the disclosed intention to generate and measure social and environmental benefits alongside a financial return.
  6. ESG integration: Systematic and explicit inclusion of ESG risks and opportunities in investment analysis.

A majority of the discourse on ESG issues has focussed on listed equities. The practice of considering ESG issues, however, can be applied to other asset classes. One notable asset class where ESG issues are having an increasing influence is in terms of fixed income.

For fixed income, ESG issues are mostly about risk. ESG analysis in fixed income considers how such issues as carbon emissions, labour relations, and corruption might affect issuers’ creditworthiness. As in equities, governance in fixed income is the most analysed of the ESG issues. For example, in an emerging market high-yield corporate debt issue, fixed income investors need to understand the full corporate structure and governance of the issuing entity and related entities before making any investment decision.

As ESG practices evolve, regulators and self-regulatory organisations (SROs) have an important role to play in establishing standards and benchmarks. I recently met with Richard Howitt, CEO of the International Integrated Reporting Council (IIRC), to discuss the role of SROs in the industry. The IIRC’s reporting framework is being implemented in over 30 countries and focusses on improving communications, including sustainability disclosures that inform investors about a company’s long-term value creation potential. I also joined a dinner in February – hosted by HRH Prince Charles – on behalf of the Accounting for Sustainability initiative, where topics such as responsible investment as a fiduciary duty across different jurisdictions was discussed.

Rules and regulations

Across the world, a range of laws and regulations addressing ESG issues are already in place with more coming. For example, the Hong Kong Stock Exchange will be requiring listed companies to make ESG disclosures on environmental key performance indicators in 2017, following global precedents. The same is happening in Singapore where listed companies are required to disclose their sustainability practices from next year.

A key question confronting Asia Pacific regulators is what approach to take in developing ESG-related regulations: Independently develop nation-specific requirements? Adopt ‘en banc’ established guidelines and/or standards? Or a mixture? The Global Reporting Initiative (GRI) guidelines (to be superseded by standards in mid-2018) have long been regarded as the benchmark for judging ESG disclosures. Asia Pacific regulators seeking to rely on GRI guidelines, however, may wish to take heed of criticism that such guidelines tend to place an emphasis on the “quantity” of disclosure rather than “quality”.

Improvements in ESG practices and regulation could very well lift the governance discount investors currently place on companies in markets where governance and transparency is poor. If markets are seen to be systematically improving governance levels, foreign inflows are likely to follow. This shift will be crucial for nations such as China as investors seek to use ESG data to help better understand companies in one of Asia’s fastest growing markets. Already, China is a growing market for green financing with the government pushing sustainable infrastructure and energy projects.

Asset managers in Asia can be instrumental in influencing ESG practices, regulations and disclosures across the region. However, asset managers need to be conscious of developments in the ESG space that may impact the investment decision-making process. For example, if there is greater adoption of UN Sustainable Development Goals (SDGs), this may result in a convergence of ESG practices and disclosures toward the four primary SDG mainstays (human rights, climate change, wealth inequality, and data and technology). Such convergence may limit the diversity of ESG data and disclosures, thereby potentially hampering asset managers in their decision-making process. Asset managers can be pivotal in determining if such convergence is warranted.

There are numerous challenges facing ESG across Asia. Presently the quality of ESG practices lags behind other regions, and is potentially declining. The 2017 Global Top 100 Sustainable Companies rankings only listed 12 companies from Asia (compared to 15 companies in 2016) with a highest ranking of 30th (highest of 8th in 2016).

Also, many companies are doing business in places that are hot beds for ESG issues such as underpaid or under-aged labour, unsustainable operations and energy sourcing, or government corruption. Fortunately, when confronted by such issues these days, the investment community has room to push for more data to better scrutinise companies. And this trend will likely intensify in the future.

A higher quantity of disclosure is only one part of the equation. Effective ESG integration into investment decisions requires ESG data that is reliable, relevant and of quality. It is therefore important for investors in Asian companies to engage these firms and to push for the data needed. ESG reporting in Asia is by no means established, and transparency remains a challenge even as the market continues to drive ESG reporting forward.  

*Paul Smith, CFA, is president and CEO of CFA Institute