SINGAPORE (Jan 31): Environmental, Social and Governance (ESG) investing is a term that is commonly associated with socially responsible investing, mission-related investing or sustainable investing. It is investing that integrates ethical, personal or moral concerns into the investment process.
The origin of ESG investing dates as far back to a few centuries ago, whereby practitioners invest their money according to their personal religious beliefs. An increase in social activism has seen ESG investing rise to prominence over the years. From the boycotting of weapon-producing companies during the Vietnam War to the divestitures of operations away from the racist system of apartheid in South Africa, investors and corporations are often driven by their ethical, personal, religious or social values.
Today, ESG investing has taken on increased significance and it is becoming an important focus for the investing world.
What does ESG factors stand for?
Environmental, Social and Governance, or ESG in short, are the three central factors concerning the measurement of the sustainability and ethical impact of an investment in a company or business. It involves evaluating how companies’ environmental, social and governance practices may affect the investment return potential.
The ESG factors are often incorporated into the investment process alongside traditional financial analysis. These factors help to better determine the future financial performance and sustainability of the companies.
For example, companies that value human rights and diversity through fair labour practices can gain access to a wider pool of talent, which could in turn benefit the companies’ financial performance in the long term.
Furthermore, a failure to address the ESG factors can expose the companies to legal, regulatory, legislative, operational, financial and reputational risks.
Three common ESG investors’ objectives
Investors adopt ESG Investing for various reasons and investors’ objectives tend to converge around three main categories; Integration, Personal Values and Positive Impact.
Why is ESG investing growing?
There are various reasons that give rise to the increasing popularity of ESG Investing and the utilisation of ESG factors to evaluate companies’ performance.
1. Alternative sources of energy Technological advancements made alternative sources of energy affordable and accessible. Therefore, it may be more economical for companies to switch to alternative or renewable sources of energy in the future. An over reliance on finite energy sources like crude oil or natural gases can create cost volatility for businesses should supply shortages occur.
2. Global supply chain network Multinational Corporations (MNCs) are corporate organizations that own or control the production of goods and services in at least one country other than its home country. The cross border coordination of business activities allow companies to capitalise on the competitive advantages that each market has to offer; low labour cost, availability of resources or abundance of skilled labour etc.
MNCs with operations in multiple markets may have to address issues like corruption practices, unfair labour practices and environmental degradation. The failure to respond to these problems may result in the costly disruption of the global supply chain network.
3. Demographic shifts The Millennials and Generation-Xers will outnumber the Baby Boomers in the near future. The change in demographic structure will result in the seismic shift of the business, political and financial landscape.
Moreover, we are in the midst of the largest intergenerational wealth transfer in history. It is estimated that US$30 trillion in assets will be transferred from the Baby Boomers to their children over the next 30 to 40 years.
The inheritors of the assets have different spending habits and investing decisions from their parents. The Bank of America Merrill Lynch predicts that Millennials could put between US$15 trillion and US$20 trillion into US domiciled ESG investments over the next two to three decades, which would nearly double the size of the entire US equity market.
4. Regulatory changes and international agreements
Following the Global Financial Crisis in 2008, there is an increased emphasis by regulators for businesses to improve their corporate governance to safeguard stakeholders’ interests. Good corporate governance is essential for the growth of the capital market ecosystem.
According to the CFA Institute, many jurisdictions require a minimum level of governance-related disclosure and reporting from companies to provide stakeholders with material ESG information.
In addition, climate change is a known fact. Mitigation techniques include international agreements like the Paris Agreement and the Kyoto Protocol. The agreements aim to strengthen the participating nations’ abilities to combat climate change and environmental degradation by providing them with the necessary framework and resources to work with. MNCs with operations in the respective countries will be encouraged to contribute to the worldwide collective efforts in combating climate change.
5. The convergence of social norms
In the past, socially responsible norms may differ by countries or regions. The advent of the Internet has created an interconnected world via the international media and social media network. Given its borderless nature, the Internet has the potential to alter the cultural and social norms of the world’s population. The convergence of social norms has resulted in the rise of social activism around the world. Companies are encouraged to address ESG-related issues in order to take advantage of the network effect of social media to generate positive publicity or to avoid negative publicity amongst the global population.
The rise of ESG ETFs
The first ESG theme Exchange Traded Fund (ETF), iShares MSCI USA ESG Select ETF, was launched in 2002. Since then, the number and variety of ESG ETFs/Exchange Traded Products (ETPs) have increased steadily, with 269 ESG ETFs/ETPs listed globally at the end of November 2019. Total Asset under Management (AUM) for ESG ETFs/ETPs has reached US$52.35 billion at the end of November 2019.
ESG ETFs are convenient investment vehicles for investors who are evaluating investments not only based on their financial goals, but also based on their personal values and social conscience. Instead of ciphering through market reports and news to identify companies with high ESG ratings, investors can now use ESG ETFs to gain exposure to their desired ESG investment strategy.
ETF strategies to achieve ESG investment objectives
ESG ETFs use a variety of strategies to achieve their ESG-focused investment objectives. Two common approaches used in ESG ETFs are the Exclusionary/Negative Screening and the Inclusionary/Positive Screening Strategies.
As the digital age flourishes, it is now fast and inexpensive for index providers and ETF issuers to gain access to ESG research and data. This helps to facilitate ESG integration into index construction and increase the potential for ETF issuers to launch a wide variety of ESG strategies ETFs.
Some ESG ETFs may adopt an actively managed strategy to select its underlying stocks based on a set of underlying factors and ESG criteria.
Other types of ETFs that may adhere to ESG principles include impact or thematic investing ETFs. Examples of such ETFs include ETFs that revolve around certain themes like gender diversity or alternative energy.
Joel Lim is the ETF Specialist at Phillip Securities where he provides sales support and trading ideas to retail investors, remisiers, in-house dealers, and fund managers. He also works closely with ETF issuers on new product and business development projects.
