Environmental, social, and governance (ESG) investment is not a new phenomenon Sustainable investing has existed on the periphery from the 1970’s, but it has exploded in the last five years. Conservative estimates place the value of ESG investing at over $20 trillion in assets under management globally. In the US alone, in early 2018 sustainable investing assets reached $12 trillion and have experienced a significant 38% growth since 2016. This trend is not driven by altruism. There is a growing body of academic evidence showing a positive correlation between ESG inclusion in investment strategies and overall corporate financial performance.
In addition to financial performance, investors and corporate leaders must now consider risk exposure associated with transnational ESG movements that exist beyond the text of law. Though corporate ESG functions have not traditionally been considered a strategic business priority, increased investor activity related to ESG will likely promote corporate reform in this area. Understanding the interaction between investors, corporations, and government will better equip leaders to address these new risks.
Trends in emerging technology, transparency requirements, and social factors are some of the primary factors driving that interaction. By evaluating the pension industry in light of those three trends, the risks and opportunities to corporate investors will become more clear.
Three Main Trends in ESG Investment
A key trend driving the rise in ESG investment is the capacity of new technology to collect, amalgamate, and analyse vast amounts of data. Technologies that allow companies to manage sustainability-related data are becoming more common even as sources of data multiply. These data sources include: emissions sources, asset footprints, employee health and safety, and diversity targets through the use of surveys, data collection, and other methods. On the corporate side, the use of these technologies supports new reporting standards, and ultimately informs the way stakeholders – from shareholders to asset managers – can better comprehend both the location and the impact of their capital.
The increasing availability of technology enabling data-collection of this type will likely have a circular effect on the legal standards and investor expectations associated with disclosure requirements. Companies that fail to adapt to the impact of this cycle may suffer from increased exposure to legal and financial risk. This phenomenon will only increase as data and technology is able to tie social and environmental impacts to the impact of assets.
An identified area of difficulty for ESG funds has been that conflicting reporting and rating standards exist globally. The confusion caused by these conflicting standards can provide contradictory information and disincentivize investment, which regulatory bodies and the investment industry are working to correct.
For example, in the area of improved climate transparency, the Task Force on Climate-related Disclosure (TCFD) was formed in 2015 to develop voluntary, consistent and comparable climate related financial disclosures for both the financial sector and key non-financial industries. TCFD has become the industry loadstone for how to incorporate and perform climate related disclosure and has had far reaching effects, even being incorporated into regulation. The European Commission has also incorporated many of the recommendations from TCFD into its own legislative and regulatory proposals.
In March 2018, the European Commission published its Action Plan on Financing Sustainable Growth, which put forward a comprehensive plan to embed sustainability within finance. In June 2018, the European Commission set up a technical expert group on sustainable finance (TEG) to assist in four key areas of the Action Plan through the development of the following: 1) a unified classification system for sustainable economic activities, 2) an EU green bond standard, 3) benchmarks for low-carbon investment strategies, and 4) guidance to improve corporate disclosure of climate-related information. The TEG released its initial thoughts in its January 2019 Report on Climate-related Disclosures prior to public consultation. Clearly inspired by TCFD, it contains similar language around transparency being rewarded through the efficient exchange of capital. Furthermore, the report explicitly says that future Non-Financial Reporting Directive (NFRD) explicitly reference the TCFD recommendations.
It is not unrealistic, therefore, to presume that the TCFD requirements will in large part be adopted into European regulation, and an ESG exercise becomes the baseline for a continent.
Climate Change and Social Conscience
While the number of concerns encompassed within ESG is expanding and includes privacy concerns, supply chain management, and sexual harassment (to name but a few), the overriding concern for most is climate change. Many people still equate ESG entirely with environmental concerns.
Climate change will increase risk for organizations across the board. First, there is the physical risk companies are exposed to through climate chaos with the increasing incidence of fires, floods, and supply chain dislocation.
Second, there is legislative risk, as companies are outmaneuvered by government responses to climate change. Indeed, we have seen an explosion in climate related legislation and policies. When the Kyoto Protocol was signed in 1997 there were only 70 laws or policies addressing climate change. In 2018 the number of laws and executive acts on the subject number reached well over 1,500. Companies risk being caught flat-footed if they do not proactively incorporate sustainability concerns into their corporate strategy.
Third, there is the financial risk of being tied to “stranded assets” (assets that become obsolete or suffer from unanticipated write-downs/devaluations) as laws restrict the value of carbon heavy assets. For example, some of the conversations around Aramco’s IPO are focused not on its suggested value but on its long term prospects in an ESG-conscious world.
Finally, shareholder power as an outlet for social reaction to ESG concerns will become more common. Stakeholders could begin to target company executives they perceive to be sitting on their hands in the face of an evolving ESG landscape. Furthermore, D&O liability with regards to the climate impact of companies is also a sector in flux (with the potential for personal liability not inconceivable in some jurisdictions). Consequently, wary directors could begin to emphasise ESG concerns out of self-interest.
How ESG Influences Global Pension Markets
In the United States, public treasuries and retirement funds hold around $6.8 trillion in assets. California represents the largest pension market. The corporate governance unit of California’s $236.9 billion State Teachers’ Retirement System recently rebranded to be a sustainable investment unit to evaluate stewardship strategies in order to focus on sustainability and long-term investments. The state selected three ESG global equity managers to run a $750 million portion of the fund.
Other state and local governments are pursuing ESG-focused investment strategies, including New Jersey, Oregon, Chicago, and Boston.
The UK has a large and well established pensions market which has a relatively low level of ESG engagement. In response, from October 2019 the Department for Work and Pensions will require investors to formally show how they are incorporating ESG standards. Indeed, trustees will have to justify ignoring ESG, switching the process from an opt-in to an opt-out. This firm push has come about because the UK lags behind both the US and Dutch pension industries in terms of ESG adoption, which the UK government sees as a risk for the sectors long term viability and dominance.
Pension assets are dominated by government bonds with many funds run by insurers. Overall, these trends – and the lack of significant equity investment – have limited ESG adoption in France. This is significant given that fact that France is a leader in other areas of sustainable finance. For example, in 2019 France overtook the US as the leader in green bonds with €15 billion issued between January and July 2019 as French companies pioneer this new product.
The disconnect between France’s wider, dynamic ESG aware financial sector and its pension market will only widen and will leave France lagging behind European and North American innovators.
The Netherlands has significant industry-based pension funds, with an impressive concentration of expertise and government engagement. They are a leader in the ESG field with it’s incorporation at a most basic level in up to 90% of all AUM in the Dutch pension sector.
Going beyond this, in December 2018, over 70 pension funds with combined assets of over €1.2 trillion signed a covenant with NGOs, trade unions, and the Dutch government with the goal of exerting their influence globally to push investment that is both environmentally and socially aware. All signatories must incorporate the OECD guidelines on tracing and reporting risk into their ESG policy by the close of 2020.
The pattern of funds moving toward ESG investment indices continues. Japan’s $1.36 trillion Government Pension Investment Fund (GPIF) takes a different approach to ESG investment. That fund does not practice negative screening (excluding companies that do not align with their ESG goals), but instead encourages cooperation with companies in regard to climate change policies rather than divestment. The fund overweights companies with strong carbon efficiency and appropriate disclosure of emissions, and underweights companies that do environmental damage. This example underscores the trend among global governments to pivot to ESG investment, but Japan’s strategy is distinguished by its lack of negative screening.
The South Korean Government Employees Pension Service (GEPS) committed 100 billion won ($88.4 million USD) to an equity fund considering ESG factors in its investment in 2018. However, from 2018-2019, these funds underperformed based on numbers representing performance of nine funds in Korea which consider ESG factors. The combined won-denominated net asset value of these funds fell 22.2 percent to 140.7 billion won ($125.19 million USD). Though South Korea’s investment strategy is generally indicative of the global trend, the performance of these funds presents a challenge for advocates of ESG investment indices.
The largest public funds in China, including the China Investment Corp (CIC), a pension administrator, and National Council for Social Security Fund, have yet to establish clear ESG targets despite the fact that the Chinese government is taking steps to establish corporate incentives for ESG goals. The China Securities Regulatory Commission has required all listed companies and bond issuers to disclose ESG risks. China also plans to expand the scope of securities including green loans and bonds. Additionally, Chinese stock exchanges have joined the UN Sustainable Stock Exchanges initiative.
China has also been host to global events that support its drive toward encourage corporate behavior toward ESG targets. Beijing hosted the First Plenary Meeting of the Green Investment Principles for the Belt and Road on August 18. This project brought world leaders from over 150 countries together in order to discuss green investment goals.