Standfirst: What does ESG mean, and its current and expected relevance in financial markets
ESG is a buzzword. Almost every think tank, organisation, corporation, or government agency is talking about it. Sustainable development goals and ESG standards are top on the agenda of many conferences.
For example, the main topics on the agenda of the 17th G20 Heads of State and Government summit to be held later this year in Bali, under the presidency of the Republic of Indonesia, are by and large sustainability-related.
Setting the scene
Climate change has increased the frequency of phenomena like drought, storms, heat waves, forest fires, along with rising sea levels, melting glaciers and warming oceans wreaking havoc on communities worldwide. According to scientists, it will only get worse unless the world halves greenhouse gas emissions by 2030 and reaches net-zero emissions by 2050, as laid out by the Paris Climate Agreement.
Getting there is simple in principle but challenging to implement in reality. Despite the desire for improving standards of living and economic growth amidst a growing world population (28% growth between now and mid-century), global emissions need to be reduced by at least 9% each year to reach the goal by 2050. Reaching the emissions target will require the collective effort of governments, companies, and the investor community.
ESG, SRI, and impact investing. What is the difference?
ESG refers to the environmental, social and governance criteria for evaluating corporate behaviour. So, instead of just looking at traditional financial metrics, ESG investing adds additional parameters to the investment analysis process. Today, over 100 rating providers offer data around ESG to investors and fund managers to support the ESG investment dimension. ESG is a framework of standards associated and aligned with the UN Sustainable Development Goals.
Socially responsible investment (SRI) goes one step further by adding factors based on specific moral beliefs or ethical considerations. For example, an investor might avoid any investments that could harm the environment. SRI, therefore, is focused on avoidance and, as such, a “passive investment strategy”.
Impact investing (II), on the other hand, seeks to achieve a positive outcome in the form of a tangible social good for the benefit of society or the environment. Impact investing, in summary, is all about creating a positive outcome and can be considered an “active investment strategy”.
ESG – a short historical overview
While the COVID-19 pandemic certainly accelerated discussions around ESG, this megatrend is not a recent development. ESG has developed 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 triggered a debate and increasing consensus that “social” in the context of value creation not only means short-term profit maximisation but long-term, sustainable profitability.
In the same year, anti-war movements led junior Senator Gaylord Nelson of Wisconsin to join 20 million to come together and protest against environmental destruction on what we now refer to in history as “Earth Day”. Earth Day marked the beginning of the creation of the United States Environmental Protection Agency and the passage of the first kind of 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 after that, Congress passed the Endangered Species Act and, soon after, the Federal Insecticide, Fungicide, and Rodenticide Act.
Other government and supranational organisations followed suit as concerns around global warming accelerated. In 1992, at the Earth Summit in Rio de Janeiro, Brazil, 154 countries signed the first international treaty.
Five years later, in 1997, the Kyoto Protocol in Japan saw 192 countries commit to limiting and reducing greenhouse gas (GHG) emissions. The protocol was extended until 2020 with the Doha Amendment in 2012.
Also established in 1997 was the Global Reporting Initiative (GRI) with a view to create an accountability framework for companies to display to their stakeholders their responsible environmental business practices.
The Carbon Disclosure Project (CDP) began in 2000 and was aimed at creating a climate change economic standard. A few years later, in 2002, CDP established its environmental disclosure programme.
ESG as an acronym was “officially” first mentioned in the 2006 United Nation’s 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 created in 2016 by UK-based ShareAction. The framework, based on the CDP collected data, is an effort to provide investors with meaningful data points for their investment analysis.
At the United Nations Framework Convention in 2015, the “famous” Paris Agreement was brought to life. At the United Nations General Assembly, the Sustainable Development Goals (SDGs) were created. The Paris Agreement’s long-term temperature goal is to keep the rise in mean global temperature to well below 2°C (3.6°F) above pre-industrial levels and preferably limit the increase to 1.5 °C (2.7 °F), recognising that this would substantially reduce the impact of climate change. The Taskforce on Climate-related Financial Disclosures (TCFD) came about in the same year to further consider climate in the global financial system.
The UN Global Compact was announced by then UN Secretary-General Kofi Annan in an address to the World Economic Forum on 31st January 1999.
More recently, in 2020, the World Economic Forum and the International Business Council (IBC), further accelerated ESG through a set of 22 parameters to an organised framework for corporates to report their results in a new “stakeholder capitalism” approach.
In the same year, The United National Global Compact was launched. This pact is “a call to companies to align strategies and operations with universal principles on human rights, labor, environment, and anti-corruption, and take actions to advance those goals.” Up until today, the Global Compact has received signatories from 13,000 plus companies across 170 nations.
Status quo ESG and financial markets
The investor community has been accelerating allocations in the ESG space. Global ESG assets increased by more than $1 trillion to $2.74 trillion in 2021, according to data from Morningstar Direct. This is an increase of 66% compared to $1.65 trillion in 2020, and more than double that of the previous period (increase of 29% in 2019 compared to 2018). At the same time, according to research data from Bloomberg, sustainable bond issuances stood at $1.6 billion in 2021 alone. Last year, the global asset management industry earned $1.8 billion in fees from sustainable asset management – $700 million more than in 2020.
Europe has been leading the way, with over 80% of global ESG assets concentrated on the continent. In 2021, Morgan Stanley’s Institute for Sustainable Investing conducted a survey that found that 79% of US individual investors with investible assets of at least $100,000 and 99% of millennials are interested in sustainable investing. Still, in contrast, in the US, only a very small portion of 401(k) pension assets is actively allocated to ESG, but this will likely change going forward.
Interestingly, despite historical performance data that shows that ESG-investments outperform the broader market performance, concerns about performance are still a big obstacle to invest sustainably. That said, Bloomberg Intelligence expects ESG investments to reach over $50 trillion by 2025, which would mean that ESG-investments at the time would account for one-third of global assets under management.
What applies to financial standards also goes for ESG, SRI, and II reporting standards. Standards provide assurance regarding measuring, assessing and comparing investment impacts. That said, currently, there are no uniform reporting standards established, and competing frameworks co-exist in Europe.
The CFA Institute’s Global ESG Disclosure Standards attempts to achieve standard harmonisation. In 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 key stakeholder group worth mentioning specifically are employees, especially within the “start-up” ecosystem. Today, the demographic group of millennials make up the majority of the workforce, followed by the Gen Z. Together they account for almost half the workforce population and it is these two groups that are especially sensitive around ESG-related corporate visions, missions and ambitions.
Ultimately, corporate leaders, irrespective of industry and geographic exposure, must increasingly consider ESG as part of the overall corporate strategy. This is a macro trend that is gaining momentum. Data shows that companies considering ESG criteria as part of their DNA are performing better than peers.
Autor: Alberto Furger