From ‘why’ to ‘why not’: Sustainable
investing as the new normal
More
institutional investors recognize environmental, social, and governance factors
as drivers of value. The key to investing effectively is to integrate these factors
across the investment process.
Sustainable investing has
come a long way. More than one-quarter of assets under management globally are
now being invested according to the premise that environmental, social, and
governance (ESG) factors can materially affect a company’s performance and
market value. The institutional investors that practice sustainable investing
now include some of the world’s largest, such as the Government Pension
Investment Fund (GPIF) of Japan, Norway’s Government Pension Fund Global
(GPFG), and the Dutch pension fund ABP.
The techniques used in sustainable investing have
advanced as well. While early ethics-based approaches such as negative
screening remain relevant today, other strategies have since developed. These
newer strategies typically put less emphasis on ethical concerns and are
designed instead to achieve a conventional investment aim: maximizing
risk-adjusted returns. Many institutional investors, particularly in Europe and
North America, have now adopted approaches that consider ESG factors in
portfolio selection and management. Others have held back, however. One common
reason is that they believe sustainable investing ordinarily produces lower
returns than conventional strategies, despite research findings to the contrary.
Among institutional investors who have embraced sustainable
investing, some have room to improve their practices. Certain
investors—even large, sophisticated ones—integrate ESG factors into their
investment processes using techniques that are less rigorous and systematic
than those they use for other investment factors. When investors bring ESG
factors into investment decisions without relying on time-tested standard
practices, their results can be compromised.
To help investors capitalize on opportunities in
sustainable investing, this article offers insights on how to integrate ESG
factors with the investment process—from defining the objectives and approach
for an investment strategy, through developing the tools and organizational
resources required to manage investments, to managing performance and reporting
outcomes to stakeholders. It is based on more than 100 interviews we conducted
with CEOs, chief investment officers, ESG leaders, investment managers, and
others at a range of investment funds, about their experiences with sustainable
investing: how they got started, what practices they follow, what challenges
they encountered, how they resolved them, and how they have enhanced their
sustainable investing approaches over time.
Sustainable investing
takes off and pays off
Once a niche practice, sustainable investing has become
a large and fast-growing major market segment. According to the Global
Sustainable Investment Alliance, at the start of 2016, sustainable investments
constituted 26 percent of assets that are professionally managed in Asia,
Australia and New Zealand, Canada, Europe, and the United States—$22.89
trillion in total.Four years earlier, they were 21.5 percent of assets.
The most widely applied sustainable investment strategy
globally, used for two-thirds of sustainable investments, is negative
screening, which involves excluding sectors, companies, or practices from
investment portfolios based on ESG criteria. But ESG integration, which is the
systematic and explicit inclusion of ESG factors in financial analysis, has
been growing at 17 percent per year. This technique is now used with nearly
half of sustainable investments.
The scale of the sustainable investing market differs
greatly from region to region. European asset managers have the highest
proportion of sustainable investments (52.6 percent at the beginning of 2016),
followed by Australia and New Zealand (50.6 percent) and Canada (37.8 percent).
Sustainable investing is less prevalent in the United States (21.6 percent),
Japan (3.4 percent), and Asian countries other than Japan (0.8 percent), but the
gap is narrowing. From 2014 to 2016, the volume of sustainably managed assets
grew significantly faster outside Europe than it did in Europe.
Recent years have also seen some of the world’s largest
institutional investors expand their sustainability efforts. Japan’s GPIF, the
largest pension fund in the world with $1.1 trillion in assets, announced in
July 2017 that it had selected three ESG indexes for its passive investments in
Japanese equities. In December 2015, the Dutch pension fund ABP, which is the
second largest in Europe, declared two ESG-related goals: to reduce the
carbon-emissions footprint of its equity portfolio by 25 percent from 2015 to
2020, and to invest €5 billion in renewable energy by 2020.
Our interviews with institutional investors reveal a
wide range of reasons they pursue sustainable investing. The three most common
motivations are as follows:
Enhancing returns.
Sustainable investing appears to have a positive effect,
if any, on returns. Researchers continue to explore the relationships between
ESG performance and corporate financial performance, and between ESG investment
strategies and investment returns. Several studies have shown that sustainable
investing and superior
investment returns are positively correlated. Other studies have
shown no correlation. Recent comprehensive research (based on more than 2,000 studies
over the last four decades) demonstrates sustainable investing is uncorrelated
with poor returns.2For
many investors, the likelihood that sustainable investing produces market-rate
returns as effectively as other investment approaches has provided convincing
grounds to pursue sustainable investment strategies—particularly in light of
the other motivations described below.
Strengthening risk management.
Institutional investors increasingly observe that risks
related to ESG issues can have a measurable effect on a company’s market value,
as well as its reputation. Companies have seen their revenues and
profits decline, for instance, after worker safety incidents, waste or
pollution spills, weather-related supply-chain disruptions, and other
ESG-related incidents have come to light. ESG issues have harmed some brands,
which can account for much of a company’s market value. Investors have also
raised questions about whether companies are positioned to succeed in the face
of risks stemming from long-term trends such as climate change and water
scarcity.
Aligning strategies with the priorities of beneficiaries
and stakeholders.
Demand from fund beneficiaries and other stakeholders
has driven some institutional investors to develop sustainable investing
strategies. This demand has followed greater public attention to the global
sustainability agenda. Sustainable investing strategies seem to have particular
appeal among younger generations: some two-thirds of high-net-worth millennials
surveyed in the United States agreed with the statement, “My investment
decisions are a way to express my social, political, or environmental values.”
More than one-third of high-net-worth baby boomers expressed the same belief—a
noteworthy proportion, given that baby boomers are a major constituency for
institutional investors.3Some
investors wish to “do good” for society by providing capital to companies with
favorable ESG features (without compromising risk-adjusted returns).
As more investors consider ESG factors, they are likely
to encounter certain common challenges. There are some lessons they should keep
in mind on how to define their approaches and maximize the benefits of
sustainable investing.
How leading investors
integrate sustainability
In reviewing the experiences of leading institutions,
one theme stands out: sustainable investing is more effective when its core
activities are integrated into existing processes, rather than carried out in parallel.
Deep integration is readily achievable because the disciplines of sustainable
investing are variations on typical investment approaches. Below, we explore
how elements of sustainable investing can be integrated with investors’
existing capabilities across six important dimensions .
Linking
sustainable investing to the mandate
To succeed, sustainable investment strategies must
derive from an institution’s overall mandate. Yet investment mandates do not
always call for sustainable strategies. The following questions can help
investors interpret their mandates with respect to ESG issues and define
targets for their sustainable investment strategies:
Does the investment mandate demand
sustainability? If so, what factors are emphasized?
Some investment mandates include ESG considerations or
even specific ESG objectives. For example, the management objectives of Norges
Bank, which manages Norway’s GPFG, call for the bank to “integrate its
responsible management efforts into the management of the GPFG” and note that
“a good long-term return is considered dependent on sustainable development in
economic, environmental, and social terms, as well as well-functioning,
legitimate and efficient markets.”
How can the directives of a more general mandate help
shape a sustainable strategy?
Many funds have a mandate similar to that of a large
Canadian pension fund: to “maximize returns without undue risk of loss.” A
focus on value creation provides the basis for a strategy that accounts for
long-term ESG trends by, for example, avoiding investments in companies or
sectors exposed to material sustainability risks.
How will the success of the sustainable investment
strategy be judged?
Leading institutional investors define and track
progress against clear metrics and targets for their sustainable strategies.
Some targets have to do with their own activities: for example, the proportion
of their portfolio managed with respect to ESG factors. (In some asset classes
such as government bonds, sustainable practices are less developed and may thus
take more time to apply than in asset classes such as public equities.) Others
might consist of goals for the ESG performance of portfolio companies, such as
reductions in carbon emissions or the ratios between executive pay and worker
pay.
Defining
the sustainable investment strategy
A sustainable investment strategy consists of building
blocks familiar to institutional investors: a balance between risk and return
and a thesis about which factors strongly influence corporate financial
performance. The following questions can help investors define these elements:
Are ESG factors more important for risk management or
value creation?
The balance between managing risks and producing
superior returns will help determine the sustainable investing strategy. If the
mandate focuses on risk management, then the strategy might be designed to
exclude companies, sectors, or geographies that investors see as particularly
risky with respect to ESG factors, or to engage in dialogue with corporate managers
about how to mitigate ESG risks. If value creation is the focus, on the other
hand, investors might overweight their portfolios with companies or sectors
that exhibit strong performance on ESG-related factors they believe are linked
to value creation.
What ESG factors are material?
At first glance, this question might seem basic.
Investors ordinarily look closely at factors they consider material and devote
less attention to other ones. (Not surprisingly, research has shown that
companies that focus on material ESG issues produce better financial
performance than those that look at all ESG issues.) Determining which ESG
factors matter, though, isn’t always easy. Some efforts to identify material
factors are under way. In the United States, for instance, the Sustainability
Accounting Standards Board has developed the leading approach for identifying
the unique ESG factors that are material in each sector. Investors may wish to
conduct additional analysis to assess materiality for their own portfolios. The
selection of material factors is often influenced to some extent by exposure to
asset classes, geographies, and specific companies. For example, governance
factors tend to be especially important for private equity
investments, since these investments are typically characterized by
large ownership shares and limited regulatory oversight.
Selecting
tools for sustainable portfolio construction and management
Most institutional investors that integrate ESG factors
in their strategies use at least one of three main techniques for portfolio
construction and management: negative screening, positive
screening, and proactive engagement. Once an investor has set priorities, it
can select these techniques accordingly, using the following questions as a
guide:
Is risk management a focus?
Negative screening is essential for investors that wish
to constrain risk. It entails excluding companies (or entire sectors or
geographies) from a portfolio based on their performance with respect to ESG
factors. Negative screening was the basis for many of the earliest sustainable
investing strategies. The availability of ESG performance data (for example,
carbon emissions) now allows investors to apply more nuanced and sophisticated
screens, filtering out companies that do not meet their standards or are below
industry averages for particular ESG factors.
Is value creation a focus?
Performance-focused investors can use negative screening
to eliminate companies that may be less likely to outperform in the long run.
They can also practice positive screening, by integrating the financial
implications of ESG performance in fundamental analysis. With this approach,
many of the same research and analysis activities that investors perform to
choose high-performing assets are extended to cover material ESG factors. In
this way, investors can seek out assets with outstanding ESG performance or
sustainability-related business priorities (such as high energy efficiency).
For example, the Third Swedish National Pension Fund (AP3) more than doubled
its investments in green bonds during 2016 to lower the fund’s carbon
footprint, on the grounds that a more sustainable portfolio can improve both
the return and the risk profile of the fund.
Does the investor engage with management teams?
Some institutional investors try to improve the
performance of portfolio companies by taking board seats or engaging in
dialogue with management. This approach can also be helpful in sustainable
investing strategies: an institutional investor might choose to acquire a stake
in a company with subpar ESG performance, then engage with its management about
potential improvements. If an institutional investor ordinarily takes board
seats or engages management teams, then it might consider adding sustainability
issues to its agenda. Some investors also take part in external collaborations,
such as Eumedion in the Netherlands, that collectively engage companies in
dialogues on sustainability issues and pool shareholder voting rights to
influence management decisions.
Developing
sustainable investment teams
A few leading investors embed ESG specialists within
their investment teams, though some opt for other arrangements. The following
three questions can help institutional investors fit their ESG-focused staff
and resources into their existing operations:
What expertise is needed to carry out the sustainable
investing strategy?
The factors and techniques an investor chooses will
determine what expertise is required. Investors that emphasize environmental
performance, for instance, will need specialists in relevant environmental
topics and management practices. Those that actively engage with management
teams may need specialists with executive experience. Companies that rely on
screening techniques will likely benefit from expertise in quantitative
analysis.
How should an investor obtain ESG expertise?
In-house ESG teams range from one or two full-time staff
members to 15 or more, depending on portfolio size and approach to sustainable
investing. Some investors may not need full-time ESG staff at all. Commercial
databases offer good-quality information about companies’ ESG performance, and
external advisors can provide targeted support. In addition, many institutional
investors take part in external networks such as the United Nations Principles
for Responsible Investment (PRI) and the Portfolio Decarbonization Coalition,
which support investors in incorporating ESG factors in their investment
decisions. Leading investors also continuously build the ESG capabilities of
their portfolio managers.
Where should ESG specialists fit into the organization?
Some investors put their ESG specialists outside
the investment team (for example, within a communications group). Leading
investors typically embed ESG experts within their investment teams, with a
head of ESG who reports to the chief investment officer. ESG specialists then
provide ongoing support to portfolio managers. Some funds have made it a
priority to hire ESG specialists with strong investment backgrounds. For
example, the Canada Pension Plan Investment Board hired a senior investment
professional as its head of ESG. Other funds have chosen not to have dedicated
ESG specialists, but to assign responsibility for related issues to ESG-trained
portfolio managers. At one Scandinavian investor, portfolio managers must fully
account for all drivers of risk and return, including those related to ESG
factors.
Monitoring
the performance of investment managers
Whether institutional investors use internal or external
managers to oversee their portfolios, they must regularly review managers’
performance. Before hiring external managers, they also conduct thorough due
diligence. Our interviews suggest that institutions with sophisticated
approaches to sustainable investing have made ESG considerations an integral
part of their performance-management processes. The following two questions can
help investors devise effective means of monitoring performance:
How can we ensure external managers conform to our
sustainable investing strategy?
Leading funds have integrated ESG elements into their
due diligence processes for external managers. The United Nations PRI has
developed an ESG-focused questionnaire for this purpose, and some investors
have created their own ESG scorecards. Side letters, which augment the terms of
a contract, can be used to specify ESG performance standards for an external
manager. Once an external manager has been hired, leading investors evaluate
their ESG performance as part of their semiannual or annual performance
reviews. The Second Swedish National Pension Fund (AP2), for example, developed
an ESG assessment tool for reviewing external private equity managers. Some
leading investors have a continuous dialogue with their external managers,
through which potential ESG issues can be flagged and discussed.
How can we ensure our in-house investment team adheres
to the sustainable strategy?
Leading funds also make ESG considerations part of their
processes for managing the performance of in-house portfolio managers. Some
funds have tools for checking whether portfolio managers have complied with ESG
requirements and, in some cases, whether the ESG performance of their
portfolios meets certain standards or contributes to the investor’s overall ESG
targets. A few investors have also begun experimenting with linking managers’
ESG performance to their compensation.
Reporting
on sustainable investing practices and performance
Leading institutional investors reinforce their
commitment to sustainable investment by disclosing performance and describing
their management practices. The most advanced provide detailed descriptions of
how they are enacting their sustainable investment strategies, along with
quantitative measures of their performance relative to targets. The following
questions can help when it comes to shaping effective approaches to external reporting:
What is the goal of reporting on ESG performance?
Investors should define what they hope to accomplish via
external reporting and disclosure. Government pensions, for example, may have
to fulfill public-policy requirements. Other institutions may wish to
demonstrate how they meet beneficiaries’ expectations, or use reporting as a
means of holding portfolio companies accountable to drive change. This
technique is particularly relevant to proactive engagement: investors can exert
influence on portfolio companies by describing the performance gaps they have
identified and the improvements that companies are making.
What information should be disclosed? Investors
generally have wide discretion on what to disclose about their sustainable
investment approach: strategies, companies excluded, ESG performance measures,
and accounts of management dialogues, to name a few. Over the past few years,
disclosures have become more detailed in areas like policies, targets and
outcomes, focus areas, and specific initiatives. For example, the Fourth
Swedish National Pension Fund (AP4) issues disclosures on all of these topics,
along with a list of excluded companies and an assessment of the direct
environmental impact of the fund’s operations.
Disclosing different kinds of ESG information serves
different purposes. To fulfill public-policy requirements and show that
practices meet beneficiaries’ expectations, some investors disclose how
policies and strategies are integrated in the investment process, measureable
ESG targets and outcomes, and data on shareholder votes or company dialogues.
To encourage portfolio companies to strengthen ESG performance, disclosing
information about high-priority ESG factors, company dialogues, and exclusion
lists may be helpful.
What’s next
Embedding sustainable investment practices into
investment processes is a long-term endeavor, by which most investors gradually
adopt more sophisticated techniques. The practices described above, already in
wide use, can help investors develop or refine sustainable investing
strategies. It is also worth considering the following approaches, which are
still evolving among investors at the front of the field:
Assessing the entire portfolio’s ESG risk exposure.
A few funds have begun to systematically assess how
their entire portfolios are exposed to material ESG risks (notably, climate
change and energy consumption). Such a broad review requires significant staff
time, resources, and capabilities. It also means developing a view on the
long-term development of ESG-related factors and related market forces (for
example, sales of electric vehicles and movements in energy prices) and their
impact on the financial performance and valuations of holdings. In addition,
advanced investors are developing dashboards of key indicators to watch, with
trigger points that call for mitigating actions to manage risks effectively.
Recent efforts to establish industry-wide standards for measuring a carbon
footprint have resulted in progress, but an established set of metrics across
most other sustainability topics has yet to be developed.
Using ESG triggers to find new investment opportunities.
If assessing a whole portfolio with regard to ESG risks
is one side of a coin, then seeking investment opportunities based on ESG factors
is the other side. As with assessing risk exposure, institutional investors
will need a point of view about ESG-related trends and their long-term effects
on asset prices. One way to develop a thesis is to identify the most
significant trends and the sectors they influence (for example, asking what
opportunities will be created by the widespread shift toward renewable energy).
Integrating the UN Sustainable Development Goals.
The 17 SDGs were developed to “end poverty, protect the
planet, and ensure prosperity for all.” Several European funds are exploring
ways to link their sustainable investing strategies to the SDGs. Early
approaches involve prioritizing certain SDGs and planning investment strategies
to improve corporate performance in those areas. For example, in July 2017, the
Dutch pension funds APG and PGGM jointly published the Sustainable Development
Investments Taxonomies, with an assessment of the investment possibilities
associated with each of the SDGs. AP2 also publishes examples of how its
investments contribute to the SDGs. This creates transparency on how the
institutional-investor community can be a catalyst for change for a more
sustainable society, addressing some of the prioritized challenges of
humankind.
The sustainable investing market has grown significantly
as demand for sustainable investment strategies has surged and as evidence has
accumulated about the benefits of investing with ESG factors in mind. Some of
the world’s leading institutional investors are at the forefront of adopting
sustainable investing strategies. Most large funds are seeking to develop their
sustainable strategies and practices, regardless of starting point. While some
are struggling to define their approach and to make good use of ESG-related
information and insights, our interviews with institutional investors make
clear that this doesn’t have to be the case. The methods that institutions
already use to select and manage portfolios are highly compatible with sustainable strategies, and close integration can have
significant benefits for institutional investors and beneficiaries alike
By
Sara Bernow, Bryce Klempner, and Clarisse Magnin October 2017
https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/from-why-to-why-not-sustainable-investing-as-the-new-normal?cid=other-eml-alt-mip-mck-oth-1710
No comments:
Post a Comment