Sustainable investments and why ESG matters
The demand for sustainable and impact investing is growing – investors now consider environmental, social and governance (ESG) factors across USD 8.72 trillion of professionally managed assets, which is a 33% increase since 2014, says Report on US Sustainable, Responsible and Impact Investing Trends as of 2016.
When working with our customers, Permian observes an increased pressure on the fund managers for solid ESG policies and implementation of sound, ESG oriented investment strategies by especially bigger, institutional investors. Some LPs say that, next to financial returns, ESG is now considered important enough to decline investments in the fund, if a manager cannot demonstrate real improvements in its portfolio’s track record on ESG. It is no longer enough to include few lines on ESG in the fund’s marketing material nor is it enough to stick to the most common practice when it comes to ESG in fund management – “exclusion strategy” or “negative screening”, which is to exclude all the so-called sin industries (such as tobacco, gambling or weapon production). Investors want to see their capital actively involved in shaping companies in such a way so that they create a positive impact on the society and environment.
What is ESG investing?
There are many definitions of ESG investing. MSCI ESG Research defines it as the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process. ESG factors taken into consideration when screening potential investments include industry specific elements such as climate change, pollution, human rights, safety, transparency, corporate governance etc. These factors will of course differ from industry to industry, but in general, at the centre of responsible investing are themes like sustainability, high ethical standards and management
Why does ESG investing matter?
ESG investing is sustainable and beneficial for businesses and investors. Studies show that companies employing sound ESG practices lower their cost of capital (both equity and debt), better operational performance, positive influence on their stock performance and fewer instances of corruption and fraud, among others. Such positive development influence managers return on investments and lower the risks. Managers don’t lose value, their portfolios benefit and portfolio companies improve their long-term viability, while at the same time they contribute to the society and environment.
As the world is changing and we now face sea levels rise, natural disasters, privacy and data security problems, demographic shift and other risk factors, it is important that fund managers re-think their investment strategies, and try to combine good financials returns with ESG principles as much as possible.
“Operating in a socially and environmentally sustainable manner can help businesses reduce their cost of capital. Investors who evaluate businesses according to their performance on sustainability issues do not have to give up financial returns because sustainability in corporate behaviour leads to long-term financial benefits. Active ownership is the strategy that will yield the best financial and sustainable results for investors” – Michael Viehls, Understanding ESG Investing, 2015
How to implement ESG in your investment strategy?
There are different strategies for how can managers incorporate ESG principles in their investment strategies:
- Exclusion strategy or negative screening – the easiest and most common used practice in the fund industry. Managers refrain from investing in so-called sin industries, which are considered unacceptable or controversial.
- Inclusion strategy or positive screening – specific companies (rather than industries) or sectors are selected for an investment portfolio based on their positive ESG performance. It also includes avoiding investments in companies that do not meet certain ESG thresholds
- Active ownership – according to the research this is the most trustworthy approach of responsible investing. Managers are not only to provide capital, they are to be actively involved in encouraging improvement on ESG issues, sit on boards and follow through on ESG undertakings and policies, which they very often help to write.
In practice, there are many different steps that managers can take as a part of their responsible investment strategies. They can include:
- integrating ESG information into investment DD processes;
- engaging – either individually or alongside other investors – with investee companies/entities on the ESG factors identified as relevant to them;
- using shareholder voting rights to influence company behaviour;
- encouraging investee companies/entities to disclose information on the ESG factors that do or could affect them;
- monitoring overall ESG risk within the portfolio, for instance by measuring the portfolio’s carbon footprint;
- contributing to the shaping of investor-relevant public policy;
- promoting wider acceptance and use of responsible investment within the investment industry.
At Permian, we spend a lot of time with our customers on discussing ESG matters and on helping them implement solid, and what’s most important, very operational ESG policies and procedures, so that they can actively contribute to the ESG performance of their portfolio companies, as it is very often requested by the LPs.
If you need any help with adjusting your responsible investment strategies, or need to build them from the scratch, feel free to contact Permian at firstname.lastname@example.org
Written by Agata Sniecikowska