How to further ESG integration

Major shifts in policy and industry as well as a lessening in obstacles have helped ESG integration to become more mainstream

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Environmental, social and governance (ESG) is becoming more widespread in investing. However, there is still a lot of room for growth.

What is encouraging though is that major shifts are taking place to encourage ESG integration as well as the lessening of barriers to ESG implementation, according to George Sullivan, executive vice president, global head of alternative investment solutions, State Street, in a report published on the website of the Alternative Investment Management Association (AIMA), which represents the global alternative management industry. Sullivan also highlights a framework for ESG integration that firms and investors can utilize.

Sullivan describes several shifts that have helped ESG integration to be mainstream, referring to a 2017 study conducted by his firm.

First, regulation changes have made it easier for public pension funds to incorporate ESG issues into their investment process, such as the US Department of Labor’s 2018 ruling on ERISA. Meanwhile the EU Non-Financial Reporting Directive requires 6,000 companies to report ESG information annually, which allows investors to be more aware of developments.

Second, an increasing number of empirical studies show a positive relationship between ESG factors and corporate financial performance, which supports the notion that managing ESG risk factors is beneficial for financial returns.

Third, several industry groups have been founded like the Sustainability Accounting Standards Board, which has led efforts to develop standards for companies to measure and report non-financial sustainability information, and the Global Sustainable Investment Alliance, which advocates for sustainability.

Traditional barriers to ESG implementation are starting to be reduced such as negative performance concerns, fiduciary duty and investors’ expectations, says Sullivan.

One of the concerns of ESG for investors is that this negatively impacts financial returns on investments. However, State Street’s 2017 study found that 48% of institutional investors said they didn’t believe ESG meant missing out on returns while only 35% thought it did.

Another concern is that fiduciary duty prevents ESG integration. Sullivan said the 2017 study showed that only 10% of respondents saw fiduciary duty as a barrier and that 40% of asset owners and 51% of asset managers worldwide see fiduciary duty shifting towards supporting ESG integration. Sullivan said this reflected a change in perception of ESG investing from activism to accounting for a set of non-financial risks.

Sullivan also highlighted that 75% of respondents in the study expected outperformance after three years, which signified that more investors are willing to look towards the long term and not just annual or short-term returns.

But while these barriers may be decreasing, others still remain such as the lack of standards for measuring ESG performance as well as a lack of ESG performance data reported by companies, which over 50% of respondents cited.

To further the integration of ESG, Sullivan introduced five key points as a framework for investors and firms.

First, firms need to take ownership by obtaining support from corporate leadership and the board for ESG strategies. Second, firms should conduct education and training on ESG, especially for sector portfolio managers and analysists. Third, investors should request companies provide all necessary ESG data. Sullivan said that 92% of respondents in his firm’s survey said they want companies to explicitly identify material ESG factors that affect financial performance.

Fourth, there is a need to adopt a materiality filter in which all relevant information that impacts investment decisions need to be made available by firms. Fifth, time horizons must be aligned, which means firms should adjust performance metrics and incentives to reflect the long-term nature of ESG investing.

While firms and investors still need to do some work to increase ESG integration, the potential and opportunities are there.

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Date

29 Apr 2019

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