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Sustainable Investment: Beyond ESG

Today, sustainable investing is a means of pursuing investment solutions to urgent challenges like climate change in order to make a fundamental impact. Oxford University released a report in which they define and explain sustainable investing as an investment strategy with deeper thinking that requires a longer-term framework for assessing success. The integration of environmental, social and governance (ESG) is an investment strategy that has proved to be advantageous for companies, asset managers and investors as they no longer have to consider a trade-off with the financial returns which have proven, especially during the pandemic, to be resilient and rewarding. This is backed by economic intuition – investments that do not consider ESG components possibly miss capturing information beyond financial returns that indicates higher risk exposure. However, how credible are ESG reports and is ESG integration the best way to combat the climate crisis?

How has the ESG market evolved?

The ESG market has recently experienced promising growth, particularly in terms of the rise in sustainable assets in Europe (cf. 1). In 2018 Europe was named the worldwide leader in sustainable investing, with its market surpassing €12.3 trillion. Due to the rapid growth of its assets, sustainable investing is becoming a mainstream investment strategy whereby clients are becoming more conscious of where their money is being invested as well as its impact.

Figure 1: The Increase in Sustainable Investment Assets in Europe (Statista)

According to the Intergovernmental Panel on Climate Change (IPCC), the average investment between 2016 and 2035 in the energy system needs to hit $2.4 trillion per year in order to keep ecosystems safe, decrease poverty and minimise severe weather conditions. Moreover, Bloomberg Corporation figures suggest measurable sustainability initiatives such as reducing emissions increased nearly seven-fold to $36 billion in 2018. Figure 1 indicates we are generating enough to meet IPCC’s target, but do investors need to focus instead on other investment strategies?

The three most common sustainable investment strategies that investors now apply are (cf. 2):

  1. Exclusion – excluding companies and industries that do not reflect your values from your portfolio.
  2. Integration – integrating ESG factors into your portfolio to improve return and reduce risk.
  3. Impact – intending to generate measurable environmental and social impact alongside financial return.
Figure 2: Global growth of Sustainable Investment Strategies between 2016 and 2018 (GSI)

Exclusion and integration are the fastest growing sustainable strategies with $19.8 trillion of assets under management (AUM) and $17.5 AUM respectively. Impact investing, however, is still in its early stages, with impact-dedicated funds only accounting for less than 1% of global investment. Despite not necessarily being implemented in portfolios at a high rate – as Figure 2 demonstrates – it is nonetheless an alternative strategy that can meet global challenges, achieve market-rate returns and align values with returns through a quantitative approach.

Shortcomings of ESG

ESG metrics are used to evaluate a company’s performance concerning ESG risks. While they are not mandatory, companies are increasingly disclosing them in their annual financial reports or in separate sustainability reports. ESG reports do however face some flaws, with inconsistencies between companies’ ESG measurements leading to investors often receiving insubstantial, incomparable and unreliable information to guide their decision-making and capital allocations. In fact, 78% of Europe’s biggest firms currently fail to report sufficient climate and environmental information to investors, according to the latest research from the Climate Disclosure Standards Board (CDSB).

The CDSB has released a report analysing the 2019 environmental and climate-related disclosures of Europe’s top 50 largest listed companies, in which it was found that company disclosure improved in 2019. However, it still faces significant downfalls, as certain companies failed to consider the strategic and financial risks on their business, assessing only the impact of their business on the environment and climate. Steve Waygood, Head of Sustainable Investing at Aviva, hopes that the EU taxonomy will provide a holistic picture allowing everyone to speak the same language in their annual ESG reports. In fact, Europe’s Sustainable Finance and Disclosure Regulation (SFDR) will require the reporting of 34 new quantitative impact performance indicators from as soon as March 2021.

ESG Taxonomy

The EU Taxonomy is a tool created by the EU Commission, that will help asset managers and investors to identify and perform environmentally sustainable investments, currently a key shortcoming of ESG integration. Fiona Reynolds, CEO of Principles of Responsible Investing (PRI), believes that Taxonomy is a crucial effort made by financial regulators to instruct disclosure against sustainability targets rather than financial ones. Currently, the Taxonomy includes a list of ‘green’ criteria that must be adhered to:

  1. Pollution prevention
  2. Climate change mitigation
  3. Climate change adaption
  4. Protection of water and marine resources
  5. Protection and restoration of ecosystems
  6. Transition to a circular economy

However, the Technical Expert Group (TEG), appointed by the EU Commission, have advised to think beyond the ‘green’ criteria. They have suggested that the Taxonomy should include environmentally harmful activities, also known as ‘brown’ activities. Central Banks and NGOs have favoured the suggestion as they believe ‘brown’ activities are a potential indicator of risk and therefore will require tougher capital requirements and other regulatory intervention in comparison to ‘green’ activities. The ‘brown’ Taxonomy will also help to incentivise investments that reduce environmental harm. The TEG’s goal is for the EU Taxonomy to comprise of three performance levels: substantial contribution (green), significant harm (brown) and a category for activities that do neither.

All in all, in light of the witness statement of Sir David Attenborough – a British broadcaster and historian best known for his nature documentaries –regarding the severity of the global climate crisis, the growing demand for ESG integration has provided companies and investors with a significant opportunity to both fight against climate change and to financially capitalise. Whilst ESG reports are not yet substantial enough for investors to use to make credible decisions, the EU Taxonomy will allow for better analysis of risk going forward in the future and will improve both the reliability of and confidence in ESG reports and measurements.