Vrishti Goel looks at the challenges facing organisations that want to consider ESG issues within their investments
With the influx of trading apps, and the decrease in spending due to the pandemic, retail investing has increased in popularity. Though investors are mostly split between fundamental and technical analysts, we can agree that the most important criteria for making an investment decision are its risk and return. However, parameters that are difficult to measure in monetary terms can also affect investment performance.
One such criterion could be environmental, social and governance (ESG), which is likely to lead to more complete analysis and better-informed decision-making, as well as contributing to a more sustainable future. There has been an explosion in ESG investing from the institutional sector during the past few years, but we are yet to see such structural change within retail assets. According to a survey conducted by Wisdom Council, 52% of UK pension contributors see the financial services sector as least likely to operate sustainably. Investors make major lifestyle changes, such as recycling and moving to green energy sources, but leave mountains of assets under management without conscious thought.
According to the data by the CFA Institute, 78% of investment firms in the Asia-Pacific region, 74% in Europe, the Middle East and Africa, and 59% in the Americas now consider ESG issues in their analysis, which has led to a rise in green and sustainable bonds over the years. Per the Climate Bond Initiative, 4,693 green bonds were issued globally between 2016 to 2019. In addition, several Sustainable Development Goal (SDG) bonds, funding initiatives focused on the UN’s SDGs, have been issued by organisations such as the World Bank and PepsiCo. The SDGs form part of the UN’s 2030 Agenda for Sustainable Development, which provides a blueprint for peace and prosperity for people and the planet, and is an urgent call for all countries to work together in global partnership.
Another new emergence in this sector is transition bonds, which raise finance to help carbon-intensive companies transition towards sustainable practices. Italian energy firm Enel has issued transition bonds worth €2.5bn, with a promise that the interest rate will rise if it fails to meet specific environmental targets.
Away from fixed-income products, there has been growth in equities financing SDGs. These include exchange-traded funds and mutual funds, with five major mutual funds having an aggregated net asset under management of US$1.85bn as of 31 May 2020. Stakeholders have also put increased pressure on organisations to divest from fossil fuels. Divestment based on morals raises concern about financial performance and fiduciary duty; on the other hand, there is a risk that climate-sensitive assets will lose value, leading many to argue that financial markets should consider stranded assets in valuation to take a complete account of risk.
With abundant options available for investors to choose from, the problem isn’t one of availability but of accessibility. With limited information, and mismatched timing between the release of ESG-related disclosures and regular financial statements, it becomes harder for investors to integrate the two. Even for the information that is available, there is a lack of user-friendly tools that can compare ESG indicators with technical and fundamental indicators. There is also a risk of greenwashing, exacerbated by the fact that there is no official database tracking private firms’ SDG investments.
Another challenge is short termism in financial markets. ESG issues come to the fore after sudden and substantial losses, by which time short-term investors have already earned good returns and closed their position. One such case where governance risk proved costly without significantly impacting short-term investors is Enron, previously a darling of Wall Street. Other cases where environmental and social risk can be attributed to a fall in long-term shareholder’s wealth was BP after its 2010 oil spill, and Lonmin, which suffered a significant fall in financial performance due to its 2012 labour relations breakdown.
Despite challenges, the availability of ESG data is on the rise, and companies are increasingly disclosing their emissions and climate change strategies. There is also a belief that, as these investments attain three-to-five-year milestones and these promises turn into results, it will be easier for investors to substantiate ESG claims. Then, perhaps, investors will see how financing habits can have a larger impact in creating a sustainable future.
Vrishti Goel is student editor
Image Credit | Simon-Scarsbrook