Integrating Social and Environmental Issues in Investment Decisions

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The financial sector is often in the news for the wrong reasons — for falling short on ethics and hurting society. The reasons for the bad press vary, but the outcome is the same: a loss of trust, which gets in the way of markets doing their job for our shared economic progress.

Traditional ethics in finance tends to focus on issues like misrepresentation, fair customer treatment, insider trading, and conflict of interest management. These are all valid and important issues, and a lot of harm can be prevented by practicing traditional ethics. But if news reports are any indication, what is increasingly expected from financial services professionals is something that goes beyond traditional ethics: taking into account the impact of finance on society and the environment.

In Asia, rapid economic growth has come with a price — for example, pollution, displacement of communities, and overcrowding in cities. The financial services sector plays an important role in such economic growth, which creates a potential opportunity to rebuild trust. What is required to take advantage of this opportunity is the systematic consideration of environmental, social, and governance (ESG) issues in decision making.

The importance of ESG issues is magnified in emerging Asia because of the heightened pressure to develop. For instance, Thailand’s banks are grappling with the social and environmental impact of financing hydropower projects along the Mekong River. The situation calls for a difficult choice between enabling a project that will provide electricity to some of the poorest regions of Asia and possibly causing community displacement and damage to biodiversity as a result. Unlike in traditional ethics, there rarely is one right answer when considering the impact of a financial decision on society and the environment.

Once considered fringe issues, ESG issues are increasingly becoming part of the metrics used by investment professionals to analyze and value the public companies they invest in. According to the Global Sustainable Investment Review 2012, at least US$13.6 trillion worth of professionally managed assets incorporate ESG concerns into their investment selection and management globally.

ESG Methodologies

You have probably come across a number of different terms for investments that take ESG issues into account: responsible investing, socially responsible investing, sustainable and responsible investing (SRI), green investing, and so on. Investors using these terms may be motivated by moral consistency (to avoid becoming party to what they consider objectionable), world improvement (to “do good” and “do no harm”), or superior investment performance (to minimize risk and maximize return). But whatever the name of the investment and the motivation of investors, the common denominator is attention to ESG issues.

These ESG issues are often intangible and require a longer-term investment horizon. Traditionally, ESG issues have been used to avoid investments that are inconsistent with the values of the investors (exclusionary screening), whether products, such as tobacco, or norms, such as labor standards. The earliest such fund in the 20th century is reportedly the Pioneer Fund in the United States, which is traced back to 1928. Over time, ESG issues have evolved.

Today, some ESG investment opportunities may be preferred over others (best in class) because of better scores on positive attributes, such as efficiencies in managing energy or waste. Investors may also try to influence corporate behavior by voting and entering into a dialogue with companies (engagement). The more recent shades of responsible investment tend to focus on long-term risks and opportunities arising out of ESG issues, sometimes by following a certain theme, such as water conservation (thematic investing).

Investors may also use combinations of the best-in-class, thematic investing, and engagement methodologies (ESG integration). The different ESG methodologies show that there is significant flexibility in how investors can consider and use these issues when investing and demonstrate that ESG methods are not confined to exclusionary screening on moral grounds.

Growing Awareness in Asia

In Asia, there is growing awareness of ESG issues among regulators. Hong Kong’s stock exchange made ESG reporting a “recommended practice” last year and may raise the obligation level to “comply or explain” by 2015. The Securities and Exchange Board of India mandated ESG disclosures for the top 100 listed companies. Singapore has released a guide on sustainability reporting and is considering establishing a sustainability index to track stocks based on ESG criteria.

But integrating ESG issues into the investment decision-making process still faces challenges. The Equator Principles, which have been adopted by 78 financial institutions worldwide, provide a framework for banks to help determine, assess, and manage environmental and social risks in project financing. But in emerging Asia, where many infrastructure projects are under way, few have reportedly adopted the Equator Principles.

It’s easy to understand the reluctance to integrate ESG issues. Analysts and institutional investors seem to prefer quantitative analysis, and ESG issues are often hard to quantify. Incentives in financial markets are often tied to short-term performance, whereas ESG risks and opportunities are realized over the long term. Institutional investors may also be concerned about conflicts existing between their fiduciary responsibilities and ESG considerations. In addition, proponents of ESG analysis are sometimes perceived as having left-wing political ideologies, which are often seen as inconsistent with free market capitalism.

The ESG body of knowledge is also in a relatively early growth phase, and many investment professionals are unlikely to have come across ESG basics — such as the principles of responsible investment — in academic programs or in the workplace. For ESG integration to become mainstream, these professionals need to debate ESG issues both in the classroom and the boardroom.

In 2008, CFA Institute published an ESG manual, Environmental, Social, and Governance Factors at Listed Companies: A Manual for Investors (PDF), designed to help investment professionals identify and properly evaluate the risks and opportunities that ESG issues present. We have continued to provide a variety of educational opportunities, including a multimedia series, to investors interested in integrating ESG issues into investment decision making and ownership practices.

Performance Debate

What is the effect on financial performance of considering ESG issues? This is a long-standing debate. Several performance studies have been conducted on the subject. For instance, the 2007 joint report of the United Nations Environment Programme Finance Initiative and Mercer reviewed 20 academic studies on this subject. It found a positive relationship between ESG factors and portfolio performance in 10 studies, with 7 more reporting a neutral effect and 3 reporting a negative relationship.

However, performance studies have their constraints. For instance, comparing the financial performance of investments and indices that take ESG considerations into account is probably constrained by variations in the methodologies used (e.g., exclusionary screening versus best in class). Having said that, from the many performance studies, it seems it is becoming increasingly difficult to criticize ESG considerations for adversely affecting performance.

Rebuilding Trust
Will considering ESG issues help the financial services rebuild trust?

The answer will depend on how these issues are considered in the investment decision-making process. Parts of the SRI sector have faced criticism of “green washing” and putting more emphasis on counting assets under management that have somehow become SRI than on the change being brought about because of these assets becoming SRI. There is a risk that the credibility of integrating ESG issues will suffer as investments are cosmetically relabeled — somehow integrating ESG considerations while remaining fundamentally unchanged.

When asked what factor has contributed the most to the current lack of trust in the finance industry, 56% of investment professionals surveyed in the CFA Institute Global Market Sentiment Survey 2013 indicated “lack of ethical culture within financial firms.” Debating ESG issues in the financial institutions should help build that ethical culture.

At the 66th CFA Institute Annual Conference in Singapore on 19–22 May 2013, industry experts will explore innovative investment strategies. It will be a good platform for idea exchange and discussion, including the integration of ESG considerations into investment decisions. Victor Hugo said that nothing is as powerful as an idea whose time has come. Given the high stakes for society and the investment profession in rebuilding trust, considering the effects of financial decisions on society and the environment ought to be one of those powerful ideas.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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