ESG: The risks and opportunities

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Matt OrsaghBy Matt Orsagh, Director, Capital Markets Policy for the CFA Institute

 

 

 

Environmental, Social and Governance (ESG) factors are slowly making their way into the mainstream investment process. Investors want more information on ESG issues to understand the ESG-related risks and opportunities of the companies in which they invest, or as we like to say, ‘know the whole story’.

Proponents of ESG integration in the investment process argue that better understanding how a company handles certain ESG risks and opportunities can help them assess if a company has a strong and sustainable long-term strategy. They also feel that ESG issues are inherently long-term issues and that companies with a better track record on ESG issues will likely be better investments over the long term.

Sceptics often say that ESG issues are already being managed and are reflected in a company’s balance sheet and income statements, even if there is not a specific line-item dedicated to them.

No matter which camp you’re in, one thing is certain; companies and their boards need  to be well-informed about the ESG risks and opportunities inherent in their businesses, because their investors increasingly are.

Investor perceptions evolving

At CFA Institute, we are educating and certifying the investment management professionals of tomorrow. The CFA curriculum touches on all manner of financial education – covering what professionals currently need to know to be considered well-versed in the financial markets of today. There have been corporate governance readings in the curriculum for more than a decade now, with the ‘E’ and the ‘S’ of ESG covered for nearly as long.

This material is included in the curriculum because the marketplace tells us that more and more asset owners are considering ESG issues in the investment process. We recently surveyed our members to better understand their perceptions of ESG issues in the investment process. You can find the results from this on the CFA Institute website, but the broad strokes are that investors are increasingly factoring ESG issues into the investment process.

Of those surveyed, 73 per cent said they take ESG issues into account in their investment analysis and decisions. When asked to rate different ESG issues by order of importance, survey respondents ranked board accountability as the most important. Most of those surveyed (57 per cent) say that ESG integration is the main way that ESG analysis makes its way into the investment process – far ahead of the exclusionary screening that many still associate with ESG analysis (36 per cent).

Where there is demand, supply will follow

What does this mean for boards? It means that investors are increasingly factoring ESG information into their investment decision-making process. Certainly, such ESG factors are not the only determinants investors use to make their investment decisions, but they are increasingly a part of the full mosaic shareowners are building to better understand the businesses in which they invest.

In recent years, the availability of ESG information has grown by leaps and bounds, largely because more and more investors are demanding the data.

According to the United Nations Principles for Responsible Investment (UN PRI), the assets under management of its signatories, who vow to integrate ESG analysis into the investment process, have grown from $6trillion to nearly $60trillion in under 10 years. Financial data providers, such as Bloomberg, have put ESG data at their clients’ fingertips to such an extent that we may now be getting to the problem of having too much ESG information.

Demand for it has caused the supply to increase greatly, as more and more companies have provided the information investors have requested. Specialised ESG service providers have jumped in to help the breach to help investors manage and interpret the flood of ESG data provided.

Some organisations, such as the Sustainability Accounting Standards Board, are trying to work with analysts and issuers to narrow the focus to the key performance indicators that matter, industry by industry. Patience by all sides will be required as standards are developed around what ESG metrics matter for which industries. After all, the double-entry accounting system that is behind the books of every major business in the world was invented hundreds of years ago – and we still have accounting issues we need to work through. The integration of ESG factors in the investing process will also take time, but there is something boards can do to help those standards develop into something meaningful and useful.

What boards can do – know the issues, own the issues

If companies’ board members aren’t sitting around the table to set standards for what ESG metrics matter, the standards will be set by someone else. It is therefore imperative that they be at the table and that they routinely have conversations with investors to better understand which ESG matters are material and which ones are not essential.

This should start by the board engaging with its largest investors to understand what concerns they have about and do not have about ESG issues. Not all significantly large investors will have an opinion on ESG issues, so boards should seek out those investors that are well-informed and thoughtful. This can help boards get ahead of any issues that may be rise and turn their understanding of ESG factors into an opportunity before they become a risk.

“Companies that are leaders in addressing ESG issues will attract the increasing number of investors who value ESG integration in the investment process”

Boards should also ensure that they take the time to understand what ESG risks and opportunities face their company. Whether this falls to a governance committee of the board or other specialised committee, once the board has the information on what ESG risk or opportunities present themselves, an action plan needs to be developed with management to address any risks and take advantage of any opportunities.

Companies that are leaders in addressing ESG issues will attract the increasing number of investors who value ESG integration in the investment process.

Companies should dedicate resources and brainpower to investor engagement and understanding the ESG issues that pose risks and opportunities to the company. It largely doesn’t matter where this responsibility lies, just that it lies with a person or a team that has the responsibility of reporting to the board. Whether this responsibility lies with the corporate secretary’s office or with a specialised chief governance officer or chief sustainability officer, or somewhere else is left up to what works best for that company and that board.

Companies should also attempt to sit at the table in the coming years where the conversations of what ESG metrics matter are being held. Whether this is talking with groups, such as the Sustainability Accounting Standards Board, about their standards or working with a group, such as  the Sustainable Stock Exchanges Initiative, that is attempting to provide investors with more information on sustainability issues, companies do themselves a favour by being involved in these conversations.

Companies that are seen by investors as leaders in addressing ESG issues are more likely to attract long-term shareowners that all boards desire.

 

About the Author:
Matt Orsagh, CFA, CIPM, is a director of capital markets policy at CFA Institute, where he focuses on corporate governance issues. He was named one of the 2008 “Rising Stars of Corporate Governance” by the Millstein Center for Corporate Governance and Performance at the Yale School of Management.