Investment - The Benefits and Challenges of ESG Adherence Perspectives for Adhering to Good Practices in ESG There are a range of viewpoints on the purpose and value, both to investors and to society more broadly, on integrating ESG factors into investing decisions. We will explore those perspectives in the next sections. Risk Perspective According to the World Economic Forum’s (WEF) top global hazards, climate now tops the risk agenda. In 2015, Mark Carney, then Governor of the Bank of England and head of the Financial Stability Board, in a speech to financial regulators that became a cornerstone for the integration of climate change, referred to climate change as the tragedy of the horizon. In his annual letter to chief executives in 2020, Larry Fink, the CEO of BlackRock, announced that the investment firm would step up its assessment of climate change in its investment research since climate change was altering the world’s financial system. In a parallel letter to its clients, BlackRock committed to divesting from its actively managed portfolios any companies that generate more than 25% of their revenues from coal production and to requiring reporting from investee companies on their climate-related risks and plans for operating under the goals of the Paris Agreement to limit global warming to less than 2°C (3.6°F) above pre-industrial levels. Fiduciary Duty and Economic Perspectives FIDUCIARY DUTY PERSPECTIVE In the current investment system, financial institutions or individuals, known as fiduciaries, manage money or other assets on behalf of beneficiaries and investors. Beneficiaries and investors rely on these fiduciaries to serve in their best interests, which are often defined purely in financial terms. Because of the misunderstanding that ESG elements are not financially relevant, some investors have used the concept of fiduciary obligation as an excuse to not include ESG issues. But increasingly, academic studies and work performed over the past decade by progressive investing associations, such the Principles for Responsible investing (PRI), have underlined that financially material ESG considerations must be incorporated into the investment decision-making process. Furthermore, failing to consider long-term value drivers, which include ESG problems, in investment practice is commonly regarded a violation of fiduciary obligation. ECONOMIC PERSPECTIVE Negative megatrends (e.g., climate change and resource scarcity) will, over time, produce a drag on economic development as fundamental inputs, such as water, energy, and land, become increasingly scarce and expensive and the prevalence of health and income inequities increases. The Financial Stability Board (FSB), an international agency that monitors and provides recommendations concerning the global financial system, has recognized climate change as a potential systemic risk. The economic ramifications of environmental difficulties (such as climate change, resource shortages, biodiversity loss, and deforestation) and social challenges (such as poverty, income inequality, and human rights) are increasingly being recognised. The Stockholm Resilience Centre has identified nine ‘planetary boundaries’ within which humanity can continue to develop and thrive for generations to come, but in 2017 found that four — climate change, loss of biosphere integrity, land system change, and altered biogeochemical cycles — had been crossed. A popular theory that builds on that of planetary borders is called ‘doughnut economics’, which blends planetary boundaries with the complementing concept of social limits. Large institutional investors have assets, which due to their scale, are widely diversified across all industries, asset classes, and locations. As a result, their portfolios are sufficiently representative of global capital markets that they effectively own a slice of the total market. Their investment returns are consequently dependent on the continuous excellent health of the overall economy.
Inefficiently allocating capital to companies with strong negative externalities can affect the profitability of other portfolio companies and the overall market return. It is in their advantage to act to decrease the economic risk offered by sustainability challenges to improve their whole, long-term financial performance. Impact, Ethics, Client, and Regulatory Perspectives Impact and Ethics Perspective Another rationale for adopting responsible investment is some investors’ idea that investments may, or should, help society alongside delivering financial gain. This attitude translates into emphasizing on investments with a positive impact and/or avoiding those with a negative impact. Client Perspective Clients are increasingly seeking for greater transparency about how and where their money is invested. This is motivated by the following: Growing awareness that ESG considerations influence firm value, returns, and reputation Increasing focus on the environmental and social implications of the enterprises in which they have invested Regulatory Perspective Regardless of their ideas or convictions, some investors are being obliged to increasingly examine ESG problems. following the mid-1990s, responsible investment regulation has increased dramatically, with a boom in policy interventions following the 2008 financial crisis. Regulatory change has also been spurred by an awareness among national and international regulators that the financial sector may play an essential role in tackling global concerns, including as climate change, modern slavery, and tax dodging. Benefits of Adhering to Good Practices in ESG One of the key motivations for ESG integration is the awareness that ESG investing can decrease risk and boost returns since it examines additional risks and injects new and forward-looking insights into the investment process. Reduced Cost and Increased Efficiency Sustainable business methods increase efficiencies by preserving resources, decreasing expenses, and boosting production. Significant cost reductions can emerge from improving operational efficiency through improved management of natural resources, such as water and energy, as well as from avoiding waste. Consider the impact of Unilever’s (UL:NYSE) eco-efficiency plan. Since 2008, Unilever avoided more than GBP639 million of energy expenditures, saved more than GBP106 million by improving water efficiency in their plants, and lowered costs by roughly GBP106 million by using fewer resources and producing less waste. Reduced Risk of Fines and State Intervention Amid rising knowledge of climate change, dwindling energy resources, and environmental effect, state and federal government agencies are establishing legislation to safeguard the environment. Integrating sustainability into a business will position it to anticipate changing requirements in a timely manner. For example, a 2019 UN Environment Programme report revealed that there has been a 38-fold rise in environmental regulations placed in place since 1972. The greatest corporate fine to date was issued against BP (BP:NYSE) in the wake of the 2010 Deepwater Horizon oil spill in the Gulf of Mexico, the largest in history. BP settled with the US Department of Justice for USD20.8 billion in 2016; the total compensation ultimately paid out by the business reportedly topped USD65 billion. Reduced Negative Externalities The term ‘externalities’ refers to circumstances in which the production or use of products and services creates costs or advantages to others that are not represented in the prices charged for them. In other words, externalities include the consumption, production, and investment decisions of organizations (and individuals) that affect others not directly participating in the transactions. In the instance of pollution, a polluter makes judgments based on solely the direct cost and profit potential involved with production and does not consider the indirect costs to those afflicted by the pollution. These indirect costs, which are not borne by the producer or consumer, may include poorer quality of life, increased healthcare costs, and forgone production opportunities — for example, when pollution impairs business operations, such as tourism. Improved Ability to Benefit from Sustainability Megatrends There are a plethora of ramifications from the so-called sustainability megatrends. Some of the megatrends that investors are increasingly concentrating on include the following: Urbanisation Technological innovation Demographic change and wealth inequality Climate change and resource scarcity Being able to integrate a response to these trends into business operations might be a success element for an investee organization. From the investment standpoint, these megatrends can be part of a successful portfolio construction approach. Therefore, business leaders, investors, economists, and governments are increasingly recognising the economic implications of social challenges (such as increasing income inequality and addressing poverty and human and labour rights abuses) and environmental issues (such as climate change, biodiversity loss, and resource scarcity). Challenges in Integrating ESG ESG investing has undergone remarkable progress in recent years, yet barriers still remain to its further growth. Some investors still doubt if considering ESG problems may add value to investment decision making despite wide-spread dissemination of studies suggesting that ESG integration can assist control volatility and boost returns. Interpretations of fiduciary obligation are partially tied to the perception of the impact of ESG investment on risk-adjusted returns. Despite regulators in several jurisdictions articulating a modern conception of fiduciary obligation, contrasting perspectives continue as to how ESG integration fits in with institutional investors’ duties. Some institutional investors remain unwilling to modify their governance processes because they see a conflict between their responsibilities to defend the financial interests of their beneficiaries and the inclusion of ESG factors. The difficulty is not just regarding the impact of ESG investing on portfolio returns. Screening, divestment, and theme investment methods entail ‘tilting’ the portfolio towards desirable ESG qualities by over- or under weighting sectors or firms that either perform well or poorly in those areas. Institutional investors may believe that this contradicts with their responsibilities to invest sensibly because it requires departing from established market standards. Despite the obstacles and concerns, there is a growing acceptance in the financial industry and in academics that ESG considerations indeed influence financial performance. An examination of more than 2,000 academic research on how ESG elements affect business ;financial performance found an overwhelming percentage of positive outcomes, with just 1 in 10 revealing a negative association.1 Various research results also indicate that engaging with firms on ESG concerns can produce value for both investors and corporations by driving improved ESG risk management and more sustainable business practices. These results give evidence that ESG problems can be financially material to companies’ performance and potentially to alpha. Challenges Prior to Wanting to Implement ESG – Challenges prior to incorporating ESG considerations include the following: The perception that incorporating ESG elements may have a negative influence on investment performance. The interpretation that fiduciary duty hinders investors from integrating ESG. The advice supplied by investment consultants and retail financial advisers has many times not been supportive of solutions that integrate ESG. Challenges Faced After the Decision to Implement ESG Challenges faced when deciding to apply ESG include the following: A lack of awareness of how to construct an investment mandate that successfully supports ESG or lack of understanding of the needs of asset owners about ESG. The impression that considerable resources, which may be missing in the market or may be pricey, are needed. These include human resources, technical capabilities, data, and tools. A gap between marketing, commitment, and delivery of funds regarding ESG performance
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