Environmental, Social and Governance (ESG) Investing
The Evolution of ESG Investing
ESG is growing in significance amongst both institutional and retail investors. The practice of ESG investing began in the 1960s as socially responsible investing, with investors excluding stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement in the South African apartheid regime.
Ethical considerations and alignment with values remain common motivations of many ESG investors but the field is rapidly growing and evolving, as many investors look to incorporate ESG factors into the investment process alongside traditional financial analysis.
ESG BENEFITS
ESG can mean different things to different people. However, we see the objectives of investors converging around three main categories.
FINANCIAL PERFORMANCE: I believe that incorporating ESG may improve my investment results.
Growing research suggests that ESG factors have contributed to long-term financial performance. ESG factors can be used to identify better-managed companies or to flag companies with business models that are likely to face headwinds or tailwinds driven by rapidly evolving regulatory, environmental, demographic or technological trends. Institutional investors are increasingly looking to ESG factors as a way to manage these risks and to achieve long-term sustainable financial performance.
VALUES & POSITIVE IMPACT: My investments should reflect my values & make a difference in the world.
Some investors consider ESG issues a means for aligning investments with their ethical, religious or political beliefs. They have typically used ESG research to screen for controversial activities such as tobacco, weapons, alcohol, gambling or fossil fuels, and to help exclude such activities from their investment universe. Unlike the ESG integration goals described above, where ESG factors are considered on the basis of their potential economic impact, values-based goals are intentionally aligned to match an investor’s beliefs.
A third group of investors focuses on the impact of their investments on the world around them. These investors may seek to direct their capital toward companies that provide solutions to environmental or social challenges and, through formal frameworks such as the UN Sustainable Development Goals (SDGs), monitor the extent to which their investments are generating positive social or environmental impacts alongside their financial returns.
LOWER RISK: I want my investments to lower my exposure to repetitional risk or legal risks.
ESG Criteria
ESG Indexes
MSCI ESG Research provides research and ratings on over 13,000 equity and fixed income issuers linked to over 590,000 equity and fixed income securities on a ‘AAA’ to ‘CCC’ scale according to their exposure to industry specific ESG risks and their ability to manage those risks relative to peers. MSCI ESG Ratings is designed to help investors identify ESG risks and opportunities within their portfolio.
MSCI ESG Ratings are used in the construction of many of MSCI's 900 ESG Indexes.
The MSCI ESG Leaders Indexes are designed to represent the performance of companies that have high Environmental, Social and Governance (ESG) performance. The MSCI ESG Leaders Indexes aim to target sector weights that reflect the relative sector weights of the underlying indexes to limit the systematic risk introduced by the ESG selection process.
The MSCI Socially Responsible Investing (SRI Indexes) are designed to exclude companies that are inconsistent with specific values-based criteria focused on products with high negative social or environmental impact and to target companies with high Environmental, Social and Governance (ESG) ratings relative to their sector peers, to ensure the inclusion of the best-in-class companies from an ESG perspective. Further, these Indexes aim to target sector weights that reflect the relative sector weights of the underlying MSCI Global Investable Market Indexes to limit the systematic risk introduced by the ESG selection process.
United Nations Principles for Responsible Investing (PRI)
Since its founding in 2006, the United Nations Principles for Responsible Investing (PRI) has attracted support from more than 1,800 signatories representing over USD $68 trillion in assets under management as of April 2017. Signatories commit to six voluntary principles, the first of which is the incorporation of ESG issues into investment analysis and decision-making.
Global Impact Investing Network (GIIN) Impact Reporting and Investment Standards (IRIS)
IRIS is an initiative of the Global Impact Investing Network (GIIN), a nonprofit organization dedicated to increasing the scale and effectiveness of impact investing. Impact investments are investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return.
The GIIN recognizes impact measurement as a core characteristic of impact investing and offers IRIS as a free public good to support transparency, credibility, and accountability in impact measurement practices across the impact investment industry.
IRIS has been an initiative of the GIIN since 2009. Prior to that, IRIS was jointly managed by The Rockefeller Foundation, Acumen, and B Lab, which began development of IRIS in early 2008 with technical support from Hitachi, Deloitte, and PricewaterhouseCoopers.
ESG Results
Better data and analytics have paved the way for numerous studies that explore ESG investing and answers the core question does ESG add value?
In a recent study, MSCI researchers focused on understanding how ESG characteristics have led to financially significant effects. The study examined how ESG information embedded within stocks is transmitted to the equity market. Borrowing from central banks, we created three “transmission channels” within a standard discounted cash flow (DCF) model. We call these the cash-flow channel, the idiosyncratic risk channel and the valuation channel. The former two channels are transmitted through corporations’ idiosyncratic risk profiles, whereas the latter transmission channel is linked to companies’ systematic risk profiles. Our research showed that ESG had an effect on valuation and performance of many of the companies in the study.
They identified three major channels from ESG to financial value. Companies with higher ESG ratings were associated with:
Higher Profitability:
Cash-flow channel: High ESG-rated companies were more competitive and generated abnormal returns, often leading to higher profitability and dividend payments, especially when compared to low ESG-rated companies.
Lower Tali Risk:
Idiosyncratic risk channel: High ESG-rated companies experienced a lower frequency of idiosyncratic risk incidents such as major drawdowns. Conversely, companies with low ESG ratings were more likely to experience major incidents.
Lower Systemic Risk:
Valuation channel: High ESG-rated companies have shown lower systematic risk exposure, evidenced by less volatile earnings and less systematic volatility. Compared to low ESG-rated companies, they also experienced lower betas and lower costs of capital.