In June, CFA Society Toronto held a three-session ESG (Environmental, Social, and Governance) bootcamp for portfolio managers, analysts, and other industry professionals looking to learn about integrating ESG into the investment process. Facilitated by ESG Global Advisors, a leading ESG advisory firm, this bootcamp included eight hours of content, discussion, and Q&A. Key members of ESG Global Advisors, along with guest leading ESG practitioners, shared their knowledge and experience in this rapidly growing field. A vast amount of information was presented at this comprehensive bootcamp; the following focuses on some of the summary conclusions within these sessions.

There is a distinction between ESG and broader corporate social responsibility

Both corporations and investors often confuse the concept of environmental, social, and governance (ESG) factors with corporate social responsibility (CSR). While some overlap exists, there is a distinction between these two terms.

Corporate social responsibility (CSR) refers to a company’s efforts to manage the social, environmental, and economic effects of its operations responsibly and in line with public expectations. The main stakeholders for these types of initiatives are usually employees, consumers, clients, suppliers, and the broader community. Examples of these corporate initiatives would be charitable giving and volunteering in the community. Normally, these issues would not be of much interest to investors or other financial market participants.

However, when CSR items include risks and opportunities that can have a financially material impact on a company’s value, they fall under the scope of ESG. Where these two concepts intersect, as shown in Figure 1, you will find items relevant for ESG investors:  examples may include criticism of Apple’s labour practices or Nike’s controversial decision to feature an ad campaign using Colin Kaepernick.

Figure 1: What is ESG?

ESG integration permits investments in any stocks or sectors

Wait, what?

It is easy to confuse ESG integration with socially responsible investing (SRI). The latter approach excludes certain securities or industries that do not align with the values of the investors. For many SRI mandates, this means avoiding stocks in industries such as alcohol, tobacco, cannabis, gaming, weapons, adult entertainment, and (increasingly) fossil fuels.

The focus of an ESG-integrated mandate is to look broadly for risks and opportunities that may not be apparent solely by focusing on the financial statements. An ESG-integrated portfolio does not limit the potential investment universe by screening out any controversial securities or companies. If the portfolio manager understands all the ESG-related risks and believes that they are being appropriately compensated for those risks, an ESG-integrated fund can hold any type of company.

It may be helpful to think of ESG integration and SRI as two possible investment approaches under responsible investment options. Another approach, impact investment, aims to generate a measurable, beneficial social or environmental impact alongside a financial return. If one looks at investment methodologies as a spectrum, then the focus gradually shifts from “value,” as with traditional investment methodologies and their emphasis on financial factors, towards “values,” which encompass a broader range of non-financial considerations (see Figure 2, opposite, top).

The growing focus on ESG is partly driven by the changing nature of corporate value

Many ESG proponents highlight how the changing nature of corporate value over the past 50 years has supported the growth of ESG integration.

In 1975, 84 percent of S&P 500 company assets were considered tangible—land, buildings, machinery, inventory, et cetera—and 16 percent intangibles. Today, those numbers are completely inverted. Eighty-four percent of a company’s value is reflected in intangible assets such as reputation, brand, intellectual property, customer loyalty, and company data.

If an investor is really trying to understand and determine value, they need to look beyond the financial statements. Incorporating ESG analysis helps investors assess the meaningful, intangible value of a business.

The UN Principles for Responsible Investment (PRI) have increased institutional pressure to adopt ESG

One of the catalysts driving investor focus on ESG has been growing adoption of the United Nations Principles for Responsible Investment (UN PRI), a voluntary set of six principles that offers guidance on how to incorporate ESG into investment practice.

Started in 2006, the PRI is a United Nations–supported international network of investors, working together to implement responsible investment through the set of six principles. The principles are based on the notion that ESG issues can affect the performance of investment portfolios and should be considered alongside more traditional financial factors if investors are to properly fulfil their fiduciary duty. The principles provide a global framework in which mainstream investors can consider these ESG issues.

Since its inception in 2006, the PRI has grown into a broad movement, with over 2,000 signatories representing AUM in excess of US$80 trillion. Judy Cotte, CEO of ESG Global Advisors, says, “Although signing is voluntary, many institutional asset managers will tell you that they need to sign the PRI if they want to stay competitive.”

ESG is relevant for other asset classes beyond equities and fixed income

ESG factors are commonly integrated throughout a variety of asset classes beyond equities and fixed income.

Judy Cotte recalls, “Many asset owners have said its integration into infrastructure and real estate actually happened more naturally and easily because of the longer-term nature of those assets and their obvious exposure to things like physical climate risk.”

The PRI advise infrastructure investors to consider a broad range of material ESG issues that these investments might face over the assets’ lifetime. These considerations could include economic developments, demographic shifts, climate change impacts, relationships with local communities, and legislative and policy changes.

While ESG integration in private equity remains low relative to other asset classes, the improving trend is encouraging. Private equity firms are regarding ESG as increasingly important, persuaded by the growing body of research showing companies that manage these issues well tend to outperform over the longer term. With European firms leading the way, and those in the Asia-Pacific region improving reporting quality, North America is lagging behind.

Changing demographics will support ESG growth as wealth is transferred to women and millennials

Changing demographics will also continue to support the growth of ESG investing, as an estimated US$68 trillion of wealth is transferred from baby boomers to younger generations over the next two decades.

This shift may happen in two stages. Since women tend to live longer than men, the money may first flow from boomer men to boomer women and then eventually to their children.

Millennials and women are looking to align values with their investments and more likely to invest in sustainable and impactful business models. A BlackRock survey found that 67 percent of millennials wanted investments to reflect their social and environmental values. For women, the number is even higher at 76 percent.

The increase in participation by women in the workforce, as older millennials move into their higher earning years, will also support this trend.

Regulators are supporting ESG adoption through increased regulations

Regulators are doing their part to support ESG growth through the growing number of regulations in these areas. Figure 4 (below) shows the number of responsible investment-related policy instruments over time across the world’s 50 largest economies.

The growth has been exponential. The PRI finds that there have been over 730 hard and soft-law policy revisions, across some 500 policy instruments, that support, encourage or require investors to consider long-term value drivers, including ESG factors.

Incorporating ESG factors is part of an investor’s fiduciary duty

Historically, there was a commonly held view among investment managers that incorporating anything other than traditional financial considerations was a breach of fiduciary duty.

But times have changed. Today, the consensus view is that fiduciaries are required to consider all material factors and, since ESG factors may be material, fiduciary duty requires you to integrate those factors into your analysis.

If there were any lingering doubts about this view, a 2019 PRI report titled Fiduciary Duty in the 21st Century should put those concerns to rest. This four-year research project went across eight jurisdictions, including Canada, doing a deep analysis of the law in each jurisdiction. The researchers concluded that for every one of those jurisdictions, not only is integrating ESG permitted but it is in fact a breach of your fiduciary duty if you are not considering ESG as part of your investment process.

In 2018, CFA Institute also supported this view by issuing a position paper on ESG integration, which included the statement “ESG factoring is consistent with a manager’s fiduciary duty to consider all relevant information and material risks in investment analysis and decision making.”

COVID-19 has helped bring many ESG factors to the forefront

The pandemic has reinforced the important role of business in society. Even in countries with a public healthcare system, like Canada, the critical role that business plays in sustaining all of us has been highlighted.

Many believe this will put a new focus on the need for companies to plan for the long term, and while doing so respect and consider the rights of all stakeholders—not just shareholders. There has been heightened scrutiny over actions companies take to protect their workers, customers, and suppliers.

Along with priorities such as health and safety, employers are expected to provide additional accommodations for employees, such as flexible work arrangements or paid leave, when necessary. And since the prospect of widespread unemployment would exacerbate the crisis and pose added risks to basic social stability and the financial markets, corporations are under added pressure to maintain employment levels even if it means lower profits in the short term.

Some investor groups have even called for financial prudence during the crisis that would suspend share buybacks and limit compensation for executive and senior management. Instead, a company’s focus should be on its employees (especially front-line employees) consumers, suppliers, and the communities in which they operate.

Incorporating ESG factors supports improved corporate and share price performance

When discussing ESG integration and performance, Judy Cotte cautions, “There are literally thousands of studies and the research goes both ways. There are studies showing no correlation between ESG and corporate performance, research that shows a neutral connection and research that shows a positive connection.

“Generally, the majority of the academic research shows us that companies that manage their ESG issues well have lower risk, lower cost of capital, better operational performance over a wide variety of measures, and better share price performance over the longer term.”

Research also shows that ESG integrated portfolios tend to outperform the broader market, particularly when combined with fundamental analysis, and applied on a sector-specific basis.

For anyone interested in digging deeper into the research, Judy highlights two meta-studies—studies of underlying academic studies. In 2015, the Journal of Sustainable Finance & Investment looked at over 2,000 underlying academic studies tracking the correlation between companies’ ESG practices and corporate financial performance (CFP). In the same year, a study from Deutsche Asset & Wealth Management and the University of Hamburg, titled ESG & Corporate Financial Performance, examined the entire universe of ESG-CFP academic review studies that had been published since 1970. The authors believe it was the most extensive review of academic literature as it related to ESG and CFP ever undertaken.

Summary

Most of the key points highlighted above were introduced in the first session of the ESG Bootcamp. Additional colour and commentary were provided as keynote and guest speakers discussed the different investment approaches falling within responsible investment and their own unique experiences with ESG integration.

The second and third sessions delved deeper into specific topics such as ESG research and ratings, performance of different responsible investment approaches, methods of integrating ESG factors into financial analysis, and a deep dive into climate change-related investment risks and opportunities.