Standfirst: What does ESG mean, and what significance does it have for the financial markets now and in the future?
ESG is a buzzword. Almost every think tank, organization, company and government agency is talking about it. Sustainable development goals and ESG standards are at the top of the agenda at many conferences.
At the 20th G20 Summit of Heads of State and Government, which will take place in Bali later this year under the chairmanship of the Republic of Indonesia, the main topics are broadly sustainability-related.
The starting point
Climate change has led to phenomena such as droughts, storms, heatwaves and forest fires becoming more frequent, while at the same time sea levels are rising, glaciers are melting and oceans are warming, with devastating consequences for people around the world. According to scientists, the situation will only get worse if the world does not halve its greenhouse gas emissions by 2030 and achieve net-zero emissions by 2050, as envisaged in the Paris Climate Agreement.
The way to achieve this is simple in principle, but difficult to implement in reality. Despite the desire for a higher standard of living and economic growth amidst a growing global population (28% growth by mid-century), global emissions must be reduced by at least 9% each year to achieve the target by 2050. Achieving the emissions target will require the combined efforts of governments, companies and the investment community.
ESG, SRI and impact investing. What is the difference?
ESG refers to environmental, social and governance criteria for evaluating corporate behavior. So instead of just looking at traditional financial metrics, ESG investing incorporates additional parameters into the investment analysis process. Today, over 100 rating providers offer ESG data to investors and fund managers to support the ESG investment dimension. ESG is a framework of standards linked to and aligned with the UN Sustainable Development Goals.
Socially responsible investing (SRI) goes a step further by adding factors based on certain moral beliefs or ethical considerations. For example, an investor might avoid any investments that could harm the environment. SRI therefore focuses on risk avoidance and is therefore a “passive investment strategy”.
Impact investing (II), on the other hand, aims to achieve a positive outcome in the form of a tangible social good for the benefit of society or the environment. In summary, impact investing is about achieving a positive outcome and can be considered an “active investment strategy”.
ESG – a brief historical overview
While the COVID-19 pandemic has certainly accelerated discussions about ESG, this megatrend is not a new development. ESG has evolved over decades and can generally be associated with the overarching concept of corporate social responsibility or CSR.
Over 50 years ago, in 1970, Milton Friedman published his essay “The Social Responsibility of Business is to Increase its Profits”, which sparked a debate and growing consensus that “social” in the context of value creation meant not just short-term profit maximization, but long-term, sustainable profitability.
That same year, the anti-war movement prompted a young Wisconsin senator, Gaylord Nelson, to join 20 million people in a protest against environmental degradation that is now known as Earth Day. Earth Day marked the beginning of the creation of the U.S. Environmental Protection Agency and the passage of the first environmental laws, such as the National Environmental Education Act, the Occupational Safety and Health Act and the Clean Air Act. Two years later, Congress passed the Clean Water Act. A year later, Congress passed the Endangered Species Act and soon thereafter the Federal Insecticide, Fungicide, and Rodenticide Act.
Other governments and supranational organizations followed suit as concerns about global warming grew. In 1992, 154 countries signed the first international treaty at the Earth Summit in Rio de Janeiro, Brazil.
Five years later, in 1997, 192 countries committed to limiting and reducing greenhouse gas emissions with the Kyoto Protocol in Japan. The protocol was extended until 2020 with the Doha Amendment in 2012.
The Global Reporting Initiative (GRI) was also founded in 1997 to create a framework for corporate accountability that enables companies to present their responsible environmental practices to their stakeholders.
The Carbon Disclosure Project (CDP) was launched in 2000 with the aim of creating an economic standard for climate change. A few years later, in 2002, the CDP launched its environmental disclosure program.
ESG as an acronym was first “officially” mentioned in the 2006 United Nations Principles for Responsible Investment (PRI) report, consisting of the Freshfield Report and “Who Cares Wins”.
Five years later, the Sustainability Accounting Standards Board (SASB) began developing sustainability standards.
The Workforce Disclosure Initiative (WDI) was launched in 2016 by ShareAction, based in the UK. The framework, which is based on data collected by the CDP, aims to provide investors with meaningful data points for their investment analysis.
At the United Nations Framework Convention in 2015, the “famous” Paris Agreement was launched. At the United Nations General Assembly, the Sustainable Development Goals (SDGs) were created. The long-term temperature goal of the Paris Agreement is to keep the increase in global average temperature to well below 2°C above pre-industrial levels and preferably limit the increase to 1.5°C, recognizing that this would significantly reduce the impact of climate change. In the same year, the Taskforce on Climate-related Financial Disclosures (TCFD) was established to further address the issue of climate in the global financial system.
The UN Global Compact was announced by then UN Secretary-General Kofi Annan in a speech to the World Economic Forum on January 31, 1999.
More recently, in 2020, the World Economic Forum and the International Business Council (IBC) further advanced ESG through a set of 22 parameters into an organized framework for corporate reporting on their results in a new “stakeholder capitalism” approach.
In the same year, the United National Global Compact was launched. This pact is “a call for companies to align their strategies and operations with universal principles in the areas of human rights, labor, environment and anti-corruption, and to take action to advance these goals.” To date, the Global Compact has been signed by more than 13,000 companies from 170 countries.
Status quo ESG and financial markets
The investment community has accelerated its allocations to ESG. According to Morningstar Direct, global ESG assets increased by more than $1 trillion to $2.74 trillion in 2021. This is an increase of 66% compared to USD 1.65 trillion in 2020 and more than double the previous period (increase of 29% in 2019 compared to 2018). At the same time, according to Bloomberg research data, sustainable bond issuance in 2021 alone amounts to USD 1.6 trillion. Last year, the global asset management industry earned USD 1.8 billion in fees from sustainable asset management – USD 700 million more than in 2020.
Europe is leading the way, with over 80% of global ESG assets concentrated on this continent. In 2021, Morgan Stanley’s Institute for Sustainable Investing conducted a survey which showed that 79% of US individual investors with investable assets of at least USD 100,000 and 99% of millennials are interested in sustainable investing. In contrast, only a very small proportion of 401(k) retirement assets in the US are actively invested in ESG investments, but this is likely to change in the future.
Interestingly, despite historical performance data showing that ESG investing outperforms the broader market, concerns about performance are still a major barrier to sustainable investing. Nevertheless, Bloomberg Intelligence expects ESG investing to reach more than USD 50 trillion by 2025, which would mean that ESG investing would account for a third of global assets under management by that time.
What applies to financial standards also applies to ESG, SRI and II reporting standards. Standards provide certainty in measuring, evaluating and comparing the impact of investments. However, there are currently no uniform reporting standards and competing frameworks coexist in Europe.
The CFA Institute’s Global ESG Disclosure Standards are an attempt to achieve standard harmonization. At the same time, the IFRS Foundation is forming the International Sustainability Standards Board (ISSB), which will create a single set of ESG standards.
ESG is increasingly becoming an important factor in a company’s success. One important stakeholder group to mention in particular is employees, especially in the start-up ecosystem. Today, the Millennial demographic makes up the majority of the workforce, followed by Generation Z. Together, they make up almost half of the workforce, and these two groups are particularly sensitive when it comes to ESG-related corporate visions, missions and ambitions.
Ultimately, regardless of industry and geography, business leaders must increasingly consider ESG as part of the overall corporate strategy. This is a macro trend that is gaining momentum. The data shows that companies that incorporate ESG criteria as part of their DNA outperform their peers.
Author: Alberto Furger