Full ESG integration – the final frontier of responsible investment?

Responsible investment is gaining traction with the wider investment community, but a number of challenges remain to achieve full ESG integration. Jessica Wettstein explains how companies and investors can overcome existing obstacles by taking a more proactive approach.

Responsible investment has come a long way. In the early days, ESG analysis was often done separately through a screening process to exclude certain industries, on moral or ethical grounds, such as tobacco or gambling. The focus was on the risk of these so-called “sin” industries. Over time, we have seen a shift towards the upside and a focus on opportunity, with the consideration of companies that score well or show significant improvements in their performance against material ESG factors.

Today, the movement behind responsible investment is gaining more and more momentum. However, it still faces a number of challenges, especially in achieving full integration in the investment appraisal process. To accelerate progress, both investors and companies need to take a more proactive approach.

How? Here, I describe three of the obstacles commonly brought to our attention, with suggestions on how both investors and companies can make adjustments to their practices.

1. ESG data, in its current form, is still too subjective and elusive in nature to be incorporated alongside financial analysis: Whilst there is a drive for investors to integrate ESG factors, a lack of complete understanding of the influence ESG considerations have on a company’s financial performance is hindering full integration. Integration itself means that one cannot isolate the direct correlation of a specific ESG factor to a company’s overall performance and value creation.

Investors need to identify material ESG-related value drivers for individual industries to enable them to integrate sustainability data in company assessment and valuation, SASB’s materiality map is a good starting point. Companies, on the other, hand need to make materiality more relevant to investors. For example, material issues need to be talked about in terms of impact on a company’s core business value – namely growth, profitability, capital efficiency and risk exposure. For example, Novo Nordisk took the first step to define what sustainable value means to the company through its Blueprint for Change Programme.

2. ESG disclosures by companies may be limited, unverified, and unstandardised, making like-for-like comparisons within and across industries difficult: Analysts have to consult many data sources and often struggle to find access to the right information. As a result, investors who source ESG data from third parties are often concerned about the quality of the data and use it only as a starting point. According to Bloomberg, only 29% of investors are confident in the ESG information they are receiving.

There is a need for investors to seek common metrics to assess and compare companies’ performance in specific issue areas. Companies, on their part, can collaborate towards a shared vision for sustainability, developing, tracking and communicating a shared set of metrics. With initiatives like the Global Reporting Initiative (GRI) Standards, this is already improving. A study titled Defining What Matters: Do companies and investors agree on what is material? found general alignment between disclosed topics and investor interests. It also provides number of ways in which companies can improve their disclosures to make them even more relevant to investors. A good idea would be to engage with your IR department to understand how sustainability can be used as a tool to bolster the business strategy in investor communications. See our paper on how to do this here.

3. ESG issues tend to influence financial performance in the long term whereas many investors, have relatively short-term horizons: There is little evidence to suggest that mainstream investors are expanding the length of their investments. Rather, they are still focused on quarterly earnings results. As such, the value of integrating ESG factors cannot be demonstrated as this is usually realised over the long term.

The responsibility falls on investors to adjust investment performance expectations, allowing longer periods for investments to fully mature before ESG integration value is realised.

Companies need to work closely with investors to share how the management of ESG factors will generate long-term value for the business. Initiatives like the Aspen Principles for Long-Term Value Creation are also helping to address the root causes of short-termism.

This begs another question. Do ESG factors actually matter to investors?

On the one hand, a lingering view suggests that ESG considerations adversely affect investment returns. On the other, a growing body of evidence shows that ESG management leads to superior portfolio performance. Perceptions are changing, according to a study by MIT Sloan Management Review and BCG, 60 percent of investment firm board members are willing to divest from companies with a poor sustainability performance.

A number of trends suggests the increasing importance of ESG integration. For example, the list of PRI (UN-Principles for Responsible Investment) signatories has grown from 63 in 2006 to 1,714 today, with Assets Under Management (AUM) having increased from US$6.5 trillion to US$ 68.4 trillion since the PRI began in 2006.

There is an increasing amount of ESG data available and additional research providers such as MSCI and Sustainalytics present. As of 2016, there 12,242 customers using ESG data from the Bloomberg terminal, compared to 1,545 in 2009.

Governments and stock exchanges are also increasingly requiring some level of sustainability reporting. In 2016, twelve stock exchanges, including the Singapore Stock Exchange (SGX), joined the SSE (Sustainable Stock Exchanges Initiative). Bursa Malaysia joined in 2015.  There is also increased campaigning activity, with over 100 investors and companies representing more than $10 trillion AUM signing letters to stock exchanges to illustrate the demand for ESG reporting from investor communications in 2016.

Perhaps it is a matter of time before ESG data becomes fully integrated into mainstream investment. But from now until then, we look back how far this movement has come, and remain heartened that the drivers are becoming increasingly aligned for more companies to take a more serious look at where their capital will come from.

The report we published last year, in association with S&P Dow Jones Indices, looks at how to bridge the gap between Investor Relations and Corporate Responsibility teams. It outlines the key barriers to long-term business thinking, explores how to demonstrate the value of sustainable business to investors and provides practical steps to facilitate collaboration between Investor Relations and CR professionals. The report marked the first installment of Corporate Citizenship’s Long-Term Value Project and was followed by our webinar Investor Perspectives on Sustainability. Stay tuned for an event at the beginning of next year!

Jessica Wettstein is a Consultant based in Corporate Citizenship’s Singapore office.