Tony Campos of Responsible Investment, FTSE Group looks at environmental, social and governance issues (ESG)
Asset owners, their consultants and fund managers have grown accustomed to considering a complex spectrum of factors when setting and implementing investment strategies. These include; increasing life expectancy of pension beneficiaries, asset diversification, the after effects of the recession, economic slowdown in western economies and Asian markets continued expansion, to name but a few. It is then understandable that adding environmental, social and governance issues (ESG) to this list opens up a whole new area to consider. Whether it is the potential impacts of climate change, increasing resource constraints, corporate governance or reputation concerns, ESG issues have risen up the agenda and need to be addressed. Many argue that these issues have a new significance post-crisis and following high-profile events such as the BP oil spill. However, despite these issues being adopted by a significant number of mainstream asset owners and managers, there are still challenges in raising awareness of the importance of ESG consideration, and the tools available to aid this process amongst the industry at large.
There are some definite signs that the materiality of ESG issues is becoming more commonly accepted. One example has been the United Nations Principles of Responsible Investment (PRI), which acts as a network of over 800 international investors whose assets, now at $22trn, work together to put responsible investment principles into practice. The fact that many of the world’s largest institutional investors and mainstream fund managers are now signatories of such a relatively young initiative, bodes well for the continued growth of ESG investment strategies.
The rise of AuM
Recent reports measuring the global market for ESG investment support this claim and share one common theme: the growth in assets under management (AuM), where a sustainable and socially responsible strategy is displaying outpaced growth amongst the overall industry. During the downturn when professionally managed assets in the US increased less than 1% from the start of 2007 to the end of 2009, the rate of asset growth in ESG funds increased by more than 13% and now totals over $3trn1. While this growth is impressive, it is Europe that has deployed the largest pools of ESG-themed assets. Indeed the European Sustainable Investment Forum has identified approximately €5trn AuM at the end of 20092.
However, despite such major advances and the growth of global ESG related AuM, some investors are still unaware of the evolution and innovation of investment tools, available to aid a long term forward-looking investment strategy. These tools, which help investors analyse companies on ESG issues, have had to adapt to the changes in business practice and the growing sophistication of this investor segment. Almost a decade ago, the FTSE4Good Index Series was launched to measure the performance of companies that meet globally recognised corporate responsibility standards, and to facilitate investment in those companies. The key to maintaining an index series like FTSE4Good is to continually evolve the selection criteria to keep pace with the advances in sustainable investment, while at the same time ensuring that the index turnover stays within acceptable levels for passive investing.
The solution has been to strengthen the FTSE4Good selection criteria through a programme of direct engagement with companies. While the index only selects companies that have demonstrated strong performance in five environmental and social themes (environmental management, climate change, human and labour rights, supply chain labour standards and countering bribery), the breadth and depth of the selection criteria have evolved over time. For example, the climate change and supply chain labour standards themes were not present when the index was launched in 2001, but were introduced as investors placed these issues more firmly on their agenda.
More recently, in September the wholesale exclusion of nuclear companies was replaced with best-practice selection criteria and the first constituent, Spain’s Iberdrola, was added to the index. The nuclear industry has typically been screened out by funds and indices like FTSE4Good; however the pressing challenges of meeting increasing energy demands through low carbon technology have re-shaped opinion.
It is not just issues, but tactics that have advanced over time. According to Eurosif the recent growth in ESG funds in Europe is due in part to investors taking a more proactive approach of dialogue to influence companies. For engagement to be successful, the dialogue must have a clear aim and timeframe. For FTSE4Good, companies are usually given 12 months to meet new criteria or risk removal from the index. During nearly ten years of engagement, 279 companies have been removed from FTSE4Good, but this is far outweighed by the 720 companies that have been added to the index series. Positive engagement can deliver results that benefit companies and at the same time provide assurance to investors that ESG risks are being managed in a transparent and rules-driven manner.
A decade of change
Over the last ten years, the quality and quantity of company disclosure has greatly improved ESG research, and in turn the analytical tools that investors rely on, supporting the growth and sophistication of strategies and funds. The improvement in company disclosure has been driven in part by investor demand, demonstrated by initiatives like the UN PRI and the growth in ESG-themed assets globally, as well as the success of high-profile investment tools like the FTSE4Good Index Series, which many constituent companies promote as a badge of their sustainability credentials. The range, severity, and complexity of ESG risks and opportunities facing companies and investors can be daunting. However, with so many other factors to consider when setting investment strategies, asset owners will increasingly rely on robust, transparent measures of ESG performance to identify how to integrate material issues into the investment decision making process.
1SIF Report on Socially Responsible Investing Trends in the United States 2010 http://www.socialinvest.org