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How does ESG create value for investors?

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How does ESG create value for investors?

The bailout of Fannie Mae and Freddie Mae; the collapse of Lehman Brothers; the takeover of Merrill Lynch by Bank of America; the liquidity crisis at AIG, and locally, the Irish banking crisis fundamentally shone the spotlight on the effectiveness of investors in their ability to influence corporate governance as shareholders.

Investors were criticised by regulators and the media for failing to use their shareholder rights to sanction companies that were taking too many short term risks.

As a result, there is a clearer understanding today on the part of institutional investors that they can and should exercise their rights as shareholders to influence corporate behaviour. Indeed they have a duty to act in the long-term best interests of their beneficiaries and clients.

Governments and regulators have responded. Indeed, the European Securities and Markets Authority has recently issued two consultations on possible amendments to mutual fund regulation in the EU to include sustainability risks requirements. It is likely the final amendments will have a profound effect on the investment process and on disclosures to the end-investor.

The origin of Environmental, Social and Governance (ESG) can be traced back to the 18th century when religious groups established socially responsible investing guidelines for their followers. There has been a recent profound shift in investors’ sentiment; the majority of investors now consider ESG factors alongside other business and market factors in their decision-making. They recognise that applying ESG principles into their analysis, policies and practices, and requiring disclosures in corporate reporting, will align them with the broader objectives of society to the benefit of the environment and society as a whole.

Sustainability professionals find that the depth and breadth of ESG factors are not fully valued by investors and company management. Investors generally find the information contained in sustainability reports difficult to use and can struggle to understand the relationship between ESG factors and their value as an investment analysis input.

ESG has many names including Responsible Investment, Impact Investing, Stewardship, Socially Responsible Investment and Sustainability Investment. However, under any name, the manner in which ESG engagement creates value for investors can be unclear.

The United Nations-supported Principles for Responsible Investment (PRI) initiative has published a set of six investment principles. These principles are encouraging the incorporation of ESG matters into investment practice. The Principles for Responsible Investment were developed by investors for investors, and major institutions have since become signatories. PRI commissioned research which identified the types of value ESG engagement dynamics create as being communicative, learning and organisational for companies and investors.

Communicative value

ESG engagements allow corporates an opportunity to understand and clarify investors’ expectations and enhance accountability through transparency and communication to investors. Companies can create awareness among investors relating to ESG strategies and performance in many ways. These include reports and investor letters, investor calls, road shows, meetings and social media.

ESG engagements can be used as a medium to periodically explain management’s side of the story to their investors by providing reliable, relevant and up-to-date information. ESG key performance indicators (KPIs) can be integrated into the standard presentation of corporate strategy to mainstream investors to help develop long-term relationships with investors.

ESG can also be translated into financial risk or opportunity. Applying a financial mind-set and terminology, finance professionals together with sustainability professionals can bring the rigour and discipline used in accounting to the collection, analysis and reporting of ESG data. They can also help communicate how prioritising ESG issues is linked to financial value within a company – for example, the financial impact of emission reduction can be translated into cost reduction.

Learning value

ESG disclosure in corporate reporting helps a company to demonstrate that it is managing its wider stakeholder impacts and risks and is mindful of its ESG performance. The communication between investors and their investee companies through ESG engagement also creates new opportunities for learning about ESG issues. Engagements can help companies to identify emerging trends, signals and the socio-political environment within which they operate. Interactions related to ESG activities with investors can be useful for companies to understand where they are placed in the ESG space compared to their peers and provide opportunities to develop deeper knowledge of their impact on society.

Risk management practices of companies can be developed based on broader industry, regulatory and societal risks to drive long-term sustainable performance and shareholder value. Investors’ knowledge of ESG can be enhanced in specific industries by engaging with multiple companies and interacting with other investors.

Organisational value

ESG engagements help companies secure and nurture relationships with investors – particularly long-term investors. ESG risks can overrule the investment thesis and result in the sale of investments or the decision not to invest in companies’ securities.

Asset managers have publicly disclosed that as a consequence of their ESG lens they have engaged with the management of corporates to better understand their ESG strategies, then selling down certain investments that failed to pass standard. ESG communication can be a channel to attract and secure the investment of specialist ESG investors as well as mainstream institutional investors interested in ESG values.

If ESG and financial analysts work more closely together on engagements organisational benefits can be derived internally. ESG engagements can also be used in overcoming the “silo” mentality that may exist within companies and between the various stakeholders within the investment value chain. Better collaboration between the investors and companies can help develop and refine engagement policies, objectives and accountability mechanisms, to create and maintain long-term relationships with investee companies’ external organisational value can be gained.

The EU Action Plan on Sustainable Finance

In March 2018, the European Commission issued an action plan on sustainable finance as part of a strategy to integrate environmental, social and governance considerations into its financial policy framework.

In May 2018, the Commission released the first legislative package under the action plan. The plan includes ten action points and three regulations in the areas of taxonomy, disclosure and low carbon benchmark. It also covers amendments to the existing MiFID2, UCITS and MIFMD level 2 regulations, alongside other consultations and non-legislative measures.

The main objectives of the action plan are:

  • to finance the transition to a more sustainable and inclusive growth,
  • to manage financial risks arising from climate change, resource depletion, environmental degradation and social issues;
  • and to foster transparency and long-termism in financial decisions.

The proposal on disclosure of ESG risks will require institutional investors to consider and disclose in a consistent and harmonised manner how ESG factors are adopted in their decision making and advisory processes. The proposed regulation will apply to asset managers (including AIF management companies), insurance undertakings, pension funds and investment advisors.

In January 2019, the EU Commission published draft rules on how investment firms and insurance distributors should take sustainability issues into account when providing advice to their clients.

In February 2019, the EU Parliament and Member States reached an agreement on two new low-carbon benchmarks to help boost investment in sustainable projects and assets. In March 2019 the Commission welcomed the political agreement reached by the European Parliament and EU Member States on new rules on disclosure requirements related to sustainable investments and sustainability risks. The agreed rules should strengthen and improve the disclosure of information by manufacturers of financial products and financial advisors to end-investors. The new regulation sets out how financial market participants and financial advisors must integrate ESG risks and opportunities in their processes, as part of their duty to act in the best interest of clients. It also sets uniform rules on how those financial market participants should inform investors about their compliance with the integration of ESG risks and opportunities.

Following the mandate granted by the EU Commission, the European Securities and Markets Authority (ESMA) has issued two consultations on possible amendments to MiFID2, UCITS and AIFMD level 2 in order to include sustainability risks requirements. All management companies, AIFM and MiFID firms will need to review processes and resources as well as sustainability risks within risk management processes.

In conclusion it can be said that investors are displaying an active approach to stewardship of assets they own or manage. It is necessary for companies to prepare for increased demands for ESG disclosures by analysing ESG impacts and then designing a plan that integrates ESG issues into the business model and reporting cycle. Integration of ESG issues into the business model and reporting cycle can support value creation, reduce risk and be a source of competitive advantage for a company.

This article was written by Muntasir Khaleik, Senior Manager in Wealth & Asset Management with EY Financial Services, and first appeared in the May 2019 edition of Finance Dublin.

Paul Traynor

Partner and Advisory Lead, Wealth & Asset Management
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