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The price of responsibility
Responsible investment – or the incorporation of environmental, social and corporate governance (ESG) factors into investment decisions – is not a new concept, nor is it a fad. And whilst the concept of responsible investment is still not deep rooted, will the idea of globally applicable principles for responsible investment, witness a major shift in thinking sparked by the challenges facing the world's economies? asks Peter Williams
A barrier to the widespread acceptance of responsible investment has been the belief that it automatically translates into underperformance. And the question remains whether responsible investment is a sustainable option in delivering returns.
A report from the United Nations1 has attempted to show that investment performance is not undermined by a regard for ESG concerns. Pressure is growing on the investment community and capital markets to make ESG considerations part of mainstream business and investment. The UN's Principles for Responsible Investment is backed by 230 institutional investors from 30 countries representing US$10 trillion in assets. Through its sheer wealth, the global financial services industry has enormous influence on the way that people live their lives and the way businesses operate. While some have argued that ESG are risk factors that can have a material impact on investment performance, a more traditional view has been that these should be regarded exclusively as a social issue. The traditional view casts doubt on whether decent returns and social responsibility really mix. If you want to be a responsible investor do you have to accept, as a consequence, lower returns?
The report from the UN and Mercer Investment Consulting has looked at the academic evidence. It is a small and evolving field. However, of the 20 academic studies reviewed, 10 reported a positive relationship between ESG factors and portfolio performance, seven were neutral and three reported a negative association. The authors' conclusion was that: ‘On balance, the evidence suggests that there at least does not appear to be a performance penalty from taking wider factors into account in the investment management process.'
It should be said that, at this stage, it is not a definitive conclusion. Responsible investment is continually evolving. The first generation of responsible investment used negative screening by excluding sectors based on ethical criteria. This was followed by positive screening or a best-in-class approach, which selects top performers within a permitted sector. Today, responsible investment is premised on the belief that ESG factors can enhance financial performance and should therefore be integrated into investment analysis, and decision-making, including ownership practices. As a result of this approach there are signs of greater shareholder activism and engagement, with an increased emphasis on being proactive.
Questions remain over the materiality of most ESG issues to the corporate world, and more rigorous quantitative ESG research is vital to improve the comparability of ESG criteria with traditional financial criteria. This area needs to be the subject of adequate information and accepted tools for analysis.
A survey by Ethical Investment Research Services (EIRIS) found that: over 90% of investors surveyed believed that ESG issues would have some impact on companies' value over the short to medium-term (three to five years); over a third considered the financial impact to affect over 10% of the value of companies; and around 10% considered over 25% of value to be at risk. The survey claimed that financially significant ESG issues affect over 50% of the FTSE All World Index series by value.
It is probable that ESG factors will become integrated into mainstream investment analysis in the next few years even though, in the end, performance will still shout most loudly for most investors. Those who advocate ESG being integrated into the performance analysis mainstream need to make the numbers and the arguments stack up. Investors still need to be reassured that there can be alignment between the goals of responsible investment and financial security. But it would be unadulterated good news if the interest of our consciences and our wallets could be as one.
Reference
(1) Demystifying Responsible Investment Performance: a joint report by the Asset Management Working Group of the United Nations Environment Programme Finance Initiative and Mercer.
Peter Williams is a journalist and a chartered accountant. He writes on accounting, financial reporting and auditing issues.
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