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Investors expect esg issues to drive returns

Both retail and institutional investors are demanding fund managers respond to ESG issues. A new generation will insist on better standards and will not accept a compromise in returns.

Once seen as a niche market segment for socially-conscious investors, Environmental, Social and Governance (ESG) investment research has gone global, including here in Australia. In the financial sector, many institutional players realise issues such as climate change, human rights, and workplace diversity can drive risks and returns. They recognise the need to be more knowledgeable on the matter and are looking for ways to integrate ESG factors into their investment process.

ESG benefits for investors with longer investment horizons

Investors have become more aware of the wider implications that ESG issues can have on a company. For example, a recent explosion in the US state of Colorado caused the shares of an oil and gas exploration company to drop significantly. This was not due to the damage to equipment or problems with production, but because investors feared the fallout from protests and mounting pressures to increase regulation. A decade ago, the market likely would not have reacted so swiftly or aggressively.

Investor focus on ESG is growing in all regions of the world, from the Nordics and the Netherlands where ESG has been on investors’ radars for decades, to the US, Canada and Australia. In Asia, China is focused on improving air and water quality and Japan is busy implementing the new stewardship code put forth by Prime Minister Abe’s government. Closer to home, the local Financial Services Council (FSC) launched Australia’s first compulsory asset stewardship code in July 2017. Compliance with this code will be mandatory for all asset manager members.

One of our recent investments in China shows how an investor can take an integrated approach to ESG research. For an investment in a Chinese beverage manufacturer, we found that 80% of the company’s facilities were located in areas of high water stress and scarcity, according to data from the Chinese Statistical Yearbook and Aqueduct’s water risk map. We queried the firm’s investor relations director, whose response supported the case to include water scarcity in our valuation model. Our analyst placed the highest valuation discount on this firm, which resulted in a 20% lower share price target.

This example demonstrates investors must take a step back and re-evaluate the stocks they own or are planning to buy. Investors can no longer just review standard financial measures such as profits, sales and the order pipeline. They also need to look at factors such as safety policies, accident rates, and carbon reduction targets. Are the policies helping the company avoid controversies? Moreover, what are the risks if something goes wrong?

Consider local and global issues

Local issues are also important. Does the company operate in a country rife with corruption risk? How are the locals reacting to a given project? Investors taking a broader viewpoint can potentially reduce their investment risks, spot new opportunities, and allow ESG to add value, especially over the longer term.

A clear example of the rise of ESG is found in the number of financial parties who have become signatories to the Principles for Responsible Investment (PRI), the world’s leading proponent of responsible investing. Currently, there are 1714 signatories with a total of $68.4 trillion under management. The PRI helps investors to incorporate ESG factors into their investment decisions.

The trend in society calls for more ESG awareness and it is a self-reinforcing process. Society expects investors to enhance their ESG research processes and the resulting improvements in investment decisions create more momentum for the societal trends.

Worldwide, for many, ESG investing is still focused solely on creating a list of companies to exclude from a portfolio. Asset owners and asset managers will need to broaden their efforts away from simple exclusionary lists, as stakeholders increasingly expect true integration across an entire portfolio not just a small portion of the investable universe.

Millennials will force this change and we see this drive has already begun here locally with ESG questions coming from both Australian institutional and retail clients alike. As they grow older, this generation will demand ESG-integrated investments, as they are already asking about the ESG policies of the companies they do business with and their own employers. In addition, this new group of investors will demand competitive returns, as they don’t believe societal value and financial performance have to be mutually exclusive.