Environmental, Social and Governance (ESG) Factors in Investing

What Are ESG Considerations?

ESG refers to Environmental, Social and Governance factors. Already a mainstream finance issue, ESG integration requires that investors and businesses incorporate these considerations into their decision-making processes. As of December 2020, more than 3000 global investors responsible for over US $100 trillion in assets were signatories of the UN Principles for Responsible Investment (PRI), up from less than US $6 trillion in 2006. Being a PRI signatory means committing to integrating ESG factors into investment and ownership decisions.

What Is Driving The Growth In ESG Integration?

Several factors are driving this dramatic growth including regulatory, reputational, and ethical pressures. However, the main force has been strong demands from customers and investors. For example, a 2020 survey by Canada’s Responsible Investment Association (RIA Canada) indicated that 72% of investors were interested in responsible investments that incorporate ESG considerations, up from 60% in 2018.

As global asset management firms urgently attempt to address these demands, they are faced with several constraints. These include the availability and consistency of ESG data, the internal capacity to deal with ESG issues, the establishment of adequate systems and processes, and the ability to attract and train qualified personnel.

What ESG Data Is Available?

According to the Global Initiative for Sustainability Ratings, there were over 125 providers of ESG data by 2016. Four of the most commonly used providers include MSCI, Sustainalytics, Bloomberg, and Refinitiv. While the categories and methods of establishing these ratings typically differ from one provider to another, they all strive to measure a company’s performance along the three measures of environment, social, and governance. For example, the MSCI ratings attempt to assess what the most significant ESG risks and opportunities are that face a particular company and its industry, how exposed the company is, how well it is managing these issues, and how it stacks up to its global industry peers.

While the availability and granularity of ESG data is still evolving, users of this data continue to express concerns over the consistency and reliability of such data. For example, a 2019 study compares the ratings for S&P 500 firms over the 2013-2017 period from six major providers and finds an overall correlation coefficient of 0.46 across the ESG ratings, ranging from a low of 0.12 to a high of 0.77. The study also reports that the average correlation in ratings is even lower across the individual E (0.43), S (0.33) and G (0.19) categories, with minimum correlations of 0.12, 0.06 and -0.04 respectively. As a result, many large investors have developed their own ESG rating systems; although most incorporate the information provided by ratings into their analysis.

How Have ESG-Focused Investment Strategies Performed?

One of the common misperceptions regarding ESG integration is that it sacrifices returns. This view is outdated and is not consistent with a wide abundance of empirical evidence. Research shows that ESG-focused investments have produced similar returns and risk levels to those associated with traditional benchmarks and strategies. If anything, the evidence indicates slight improvements in terms of risk reduction, with no corresponding reduction in returns.

In 2015, Deutsche Asset & Wealth Management and Hamburg University conducted a comprehensive review of over 2,000 empirical studies. They found that most of the studies show a positive correlation between ESG standards and corporate financial performance, and that on balance, ESG strategies clearly did not under-perform. Numerous recent studies have provided support for these general conclusions. For example, a 2019 study of close to 11,000 mutual funds over the 2004-2018 period from the Morgan Stanley Institute for Sustainable Investing found that sustainable funds provided returns that were not significantly different than those of traditional funds, while providing lower downside risk.

What Are The Benefits To Integrating ESG Considerations?

First, ESG integration can lead to an improved reputation and a higher level of stakeholder satisfaction, including customers, employees, creditors, and investors. Second, as mentioned above, there are also opportunities to offer improvements in investment performance. Third, there are inherent benefits to taking a long-term strategic approach to systemic global issues in terms of identifying profitable opportunities, and in managing the associated risks. As noted by the CFA Institute, “systematically considering ESG issues will likely lead to more complete analyses and better-informed investment decisions.”

What’s Happening In Canada?

At the institutional level, RBC’s 2020 Responsible Investment Survey of 809 global institutional investors and investment consultants found that 75% of those surveyed integrate ESG factors into their investment decisions. Among the Canadians included in this survey:

• 87% believe that integrating ESG factors can help mitigate risk;
• 70% believe ESG-integrated portfolios help generate long-term sustainable alpha;
• 63% integrated ESG factors because they believed it was a component of their fiduciary duty.

These survey results are consistent with the fact that there are currently over 150 Canadian asset owners and managers who are PRI signatories. RIA Canada’s 2020 survey shows that CAD $3.2 trillion in assets are managed in alignment with a “responsible” investment strategy by the end of 2019, more than six times the 2006 figure of $459.5 billion. The report notes that this represents 61.8% of Canada’s investment industry, up from 50.6% two years prior.

Source: 2020 Canadian RI Trends Report