ESG investing: The challenges of a growing market

Transcription

1 June 2011 Information for Investment Professionals Integrating the four pillars of investment 1 ESG investing: The challenges of a growing market

2 2 Integrating the four pillars of investment Contents 1. Overview of terminology 2. The global SRI market is a 7.6 trillion business and growing There are a number of Social Investment Forums (SIFs) around the world The broad approach to SRI is increasingly favoured over the core 3. ESG principles and procedures are based on voluntary standards The UN Principles for Responsible Investment (UN PRI) has signatories across the globe The UK Stewardship Code grew out of a lack of active investor ownership prior to the last recession 4. Different SRI strategies are pursued across the globe Europe dominates the global SRI market Approaches to SRI differ across European markets The United States has over $3 trillion in SRI AUM Malaysia has a large number of faith-based SRI funds 5. Challenges to the future growth of ESG Institutional investors are driving client demand for ESG integration The value proposition how ESG integration adds value to the portfolio There is a need for education, resources and development of the market research process 6. ESG integration in emerging markets poses particular challenges Improving emerging market company risk disclosure is fundamental to better investment opportunity Diverse social customs create enormous variation in corporate culture across the globe Corporate governance and stewardship in a global economy The challenges of integrating ESG into emerging markets can be overcome 7. Conclusion: More change is needed to build a bridge between sustainability and capital markets 8. Appendix 9. Glossary 10. References

3 Integrating the four pillars of investment 3 Overview of terminology The world of responsible investing is one filled with jargon, much of which is not well understood. Many acronyms are used interchangeably, often without regard to the important subtle differences underlying definitions. Like any policy area, SRI is continuing to evolve and it is this process of development that gives rise to different and new waves of approaches, definitions and acronyms. This table clarifies a selection of key acronyms and definitions commonly used in responsible investment. Definitions and approaches to sustainable and responsible investment SRI ESG GRI Socially/Sustainable and Responsible Investment Environment, Social and Governance Governance and Responsible Investment Socially responsible investing is an investment discipline for the retail financial sector that may incorporate ESG issues as well as other criteria more closely linked to a values-based approach. Investors choose to exclude or select particular companies or sectors because of their impact on the environment or stakeholders. SRI is the original term employed and lacks the clarity of ESG. The incorporation of environmental, social and governance criteria or factors into investment analysis, policy or management. This term is now taking increasing precedence over SRI as it encapsulates the three key aspects of responsible investing and can be applied as an overlay to traditional investment analysis. A more clear alternative acronym to SRI. By not specifically mentioning social, GRI can include both the environmental and social aspects of responsible investment as well as governance. CG Corporate Governance Corporate governance is the means by which decisions are made relating to the control of a corporation and its stock. Corporate governance encompasses processes, customs, policies, laws and institutions affecting the way a company is directed, administered or controlled. CSR Core SRI Corporate Social Responsibility Corporate social responsibility is a form of corporate self-regulation integrated into a business model. The core SRI segment is made up of five investment (sub) approaches, which encompass either positive or negative screening methods. Positive screening A stock selection of companies that perform best against a defined set of ESG criteria. This may include best in class or SRI theme funds. Best in class Best in class is a subset of positive screening. Leading companies with respect to ESG criteria within each sector or industry are identified and included in the portfolio. No industry is excluded on ethical grounds, but companies are screened on an ESG basis to identify the best in class which could be eligible for investment. SRI theme funds Theme funds are a subset of positive screening. These funds are created around a sector such as energy, or socio-environmental issues such as the transition to sustainable development. The fund needs to have an explicit SRI motivation, showing that ESG considerations have been incorporated into the fund construction process. This in turn dictates that specific mechanisms be in place, such as the involvement of SRI expertise in stock analysis selection, the application of an ESG screen, or the management of the product by an SRI team.

4 4 Integrating the four pillars of investment Broad SRI Valuesbased exclusions Exclusion of a company s stock from a fund based on the application of two or more negative criteria/filters (as opposed to just tobacco or weapons, for example). The broad SRI segment approaches SRI through emphasising strategies of engagement and integration. Integration Engagement Normsbased exclusions A commitment to a process of dialogue with a company with the specific aim of influencing company behaviour in relation to their ESG principles. Taking an active part in the way a company is run aims to have a positive effect on sustainability. Specific inclusion of ESG-risk into traditional financial analysis, with corporate governance risk limited to its interaction with social and environmental issues. Negative screening of companies based on their compliance with international standards and norms such as issued by the OECD or ILO, for example. Policy and guidelines UN PRI OECD Principles of Governance UK CG Code UK Stewardship Code EFAMA Code for External Governance UN Principles for Responsible Investment Introduced in 2006, the UN PRI is a set of six principles, designed to provide a best-practice framework for investment managers and asset owners. These are the key international guidelines to help the investment community integrate consideration of environmental, social and governance (ESG) issues into investment decision-making. First published in 1999, the OECD Principles of Corporate Governance set out good practice in corporate behaviour and have been adopted as a benchmark in OECD countries and elsewhere. They are used as one of 12 key standards by the Financial Stability Forum for ensuring international financial stability and by the World Bank in its work to improve corporate governance in emerging markets. UK Corporate Governance Code The UK Corporate Governance Code (formerly the Combined Code) came into effect in 2010 and sets out standards of good practice in relation to board leadership and effectiveness, remuneration, accountability and relations with shareholders. Most developed markets around the world have developed their own governance guidelines which are followed to varying degrees. The UK Stewardship Code was published in It aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibility. The European Fund and Asset Management Association (EFAMA) published the EFAMA Code for External Governance in May EFAMA believes that good standards of governance are critical to ensuring confidence in European capital markets. The purpose of the EFAMA Code for External Governance is to provide a framework of high-level principles and best practice recommendations to act as a catalyst for engagement between investment management companies and the companies in which they invest. Membership organisations Membership associations are for professionals, firms, institutions and organisations engaged in socially responsible and sustainable investing. They engage in research, promote collective engagement and exist to help members to advance investment practices that consider environmental, social and corporate governance criteria. Organisations include Social Investment Forums (SIFs) around the globe. SIF Eurosif United States Social Investment Forum Set up in 1981, this was the first SIF to be established. Eurosif is a partnership of the national Sustainable Investment Forums (SIFs) within the EU. The five SIFs that founded Eurosif in 2001 are from France, Germany, Italy, the Netherlands and the UK. The Belgian, Spanish and Swedish SIFs joined later as members. Eurosif has four objects: EU lobbying, research, events and communications to promote discussion about sustainable financial services, and to expand the European network.

5 Integrating the four pillars of investment 5 UKSIF SIO ASrIA RIAA UN Global Compact ICGN ACGA ABI UK Sustainable Investment and Finance UKSIF is a membership network for sustainable and responsible financial services in the UK. UKSIF was established in Social Investment Organisation The Canadian association for responsible investment. Association for Sustainable and Responsible Investment in Asia Founded in 2001, ASrIA is a membership association dedicated to promoting corporate responsibility and sustainable investment practice in the Asia Pacific region. Responsible Investment Association of Australasia Launched in 2000, the RIAA promotes responsible investment in Australia and New Zealand. The UN Global Compact was launched in 2000 and has ten principles in the areas of human rights, labour, the environment and anti-corruption. The principles are derived from: The Universal Declaration of Human Rights The International Labour Organization s Declaration on Fundamental Principles and Rights at Work The Rio Declaration on Environment and Development The United Nations Convention Against Corruption International Corporate Governance Network The ICGN is a global membership organisation of over 500 leaders in corporate governance (mostly institutional investors) based in 50 countries with the aim of raising standards of corporate governance worldwide. It was established in Asian Corporate Governance Association Formed in 1999, ACGA works with investors, companies and regulators in the implementation of effective corporate governance practices throughout Asia. Association of British Insurers The ABI has over 300 members and a leading association for the UK s insurance, investment and long-term savings industry. Source: Organisation websites. The global SRI market is a 7.6 trillion business and growing Socially or sustainable and responsible investing, hereafter referred to as SRI, is not a new phenomenon. The principle has been around at least since the slave trade, when some decided that it was worth giving up an economic benefit for a greater moral good. Similarly, some 200 years ago the Methodist founder, John Wesley, warned his followers against profiting from their neighbours by partnering or investing with those who earned their money though alcohol, tobacco, weapons or gambling. This kind of moral imperative took on a more mass appeal when activists fighting against the Vietnam War advocated the boycott of companies supplying weapons for the war effort. Other mass international campaigns include the anti-apartheid movement which boycotted products from South Africa and also adopted an alternative approach to bringing about change through activists buying shares in companies active in South Africa so that they could influence the companies decision-making outcomes. 1 From a funds perspective, there are responsible and sustainable investment funds in the Eurekahedge Global SRI Fund database that date back to the 1950s. Churches, NGOs and charities will often, for ethical reasons, elect not to invest in particular companies. However, it is not this type of organisation that has represented the main growth in the SRI market over the past years. What has propelled SRI in the last three years in particular is the growing belief that material issues pertaining to environment, social and governance (ESG), can be, and ought to be, incorporated into an assessment of the financial fundamentals of a corporation. According to the UN PRI (UN Principles for Responsible Investment), there is increasing evidence that ESG issues can be material to performance of portfolios, particularly over the long term. 2 This notion is at the heart of a move away from the notion of socially responsible investing to a greater emphasis on integration of environmental, social and governance principles into the investment process.

6 6 Integrating the four pillars of investment The SRI investment world is growing in importance as investors recognise both their ability to reinforce responsible corporate behaviour and the potential to enhance long-term fund returns using an SRI framework. We believe that, within our active investment approach, a proper consideration of environmental, social and governance factors will help us to quantify corporate risks as well as the opportunities arising from best practices. There are a number of Social Investment Forums (SIFs) around the world There are several social investment organisations globally, which promote sustainability in financial markets. Australia and New Zealand have their own social forum, the Responsible Investment Association Australasia (RIAA), which was formed in 1999, while the Asian body is called ASrIA, the Association for Sustainable and Responsible Investment in Asia. It began in 2001 and its members include investment institutions managing over $4 trillion in assets. In the US, the social investment body is called the Social Investment Forum, and has 400 members, while Canada has an association known as the Social Investment Organisation (SIO), which was established in The pan-european sustainability forum is Eurosif, which acts as a partnership of the national Sustainable Investment Forums within Europe, supported by member affiliates. Five European SIFs originally founded Eurosif in 2001: France, Germany, Italy, The Netherlands and the UK. Other national bodies later joined the organisation. Social Investment Forums around the globe Jeremy Podger, Head of Global Equities, Threadneedle Asset Management Belgium France The Netherlands Denmark Norway USA Finland Spanish Canada Austria, Germany & Switzerland Sweden Asia Belgium UK Australia & New Zealand

7 Integrating the four pillars of investment 7 International guidelines and forums have evolved over time United States SIF established. The International Corporate Governance Network established, with the aim of raising standards of corporate governance globally. Responsible Investment of Australasia (RIAA) established. The UK and four other EU member states form Eurosif. The UK becomes the first country to publish a Stewardship code UKSIF launched, later changing its name to UK Sustainable Investment and Finance. Publication of OECD Principles of Corporate Governance. UN Global Compact launched, setting out ten principles for businesses that are committed to aligning their operations and strategies in relation to human rights, labour, environment and anti-corruption. Association for Sustainable and Responsible Investment in Asia (ASrIA) is formed. UN PRI comes into existence after a nine month deliberation process involving a group of 20 institutional investors from 12 countries, supported by a 70-person multistakeholder group of experts from the investment industry, intergovernmental and governmental organisations, civil society and academia. The UK Corporate Governance code comes into existence, replacing the combined Code. The broad approach to SRI is increasingly favoured over the core SRI can be segmented into core and broad strategies, which represent different approaches to SRI. The core approach takes a moral decision around the ethical criteria and the initial screen for an acceptable investment universe is not necessarily driven by financial materiality. The core approach incorporates positive screening and norms/value based screens. The broad approach, which emphasises engagement and the integration of ESG into the traditional investment process, engagement and simple norms-based exclusion. The broad approach increasingly dominates the world of responsible investment. The integration of ESG principles into traditional financial analysis creates a more holistic investment approach. Engagement refers to the concept of not divesting a company with poor ESG performance, but instead using investor influence to engage with the company to improve their SRI profile. Broad SRI practitioners tend to be large institutional investors, with this segment often considered to represent the mainstreaming of SRI and the growing interest of responsible investors in this area. As a consequence, the volume of broad SRI is generally much larger than core SRI. 3 Importantly for asset managers selecting this approach, there is no dominant moral imperative in that the approach does not encompass an ethical stance, rather a focus on the financial materiality. The integration and engagement approach can be coupled with simple norms-based exclusion but the criteria will be set by the asset owner for moral reasons.

8 8 Integrating the four pillars of investment ESG principles and procedures are based on voluntary standards There are no mandatory standards that determine whether or not a fund is ESG compliant. There has been an ad hoc development of various frameworks for analysing and implementing ESG principles as a result of different issues having relevance in different countries and regions. There is not even international agreement on the definitions of ESG and SRI. This means that attaining international consistency or harmonisation is a difficult process as countries differ philosophically in what they classify as ESG investment. However, the ad hoc evolution of definitions and practices is positive for both innovation and flexibility and is necessary to meet the ethical beliefs of a diverse global population. Accordingly, Threadneedle s SRI policy follows governance and responsible investment principles, drafted in line with a number of external organisations recommendations, including the UN PRI. These guidelines carry no legal / regulatory sanctions should corporate bodies not comply, although signatories are monitored and may be removed from membership. The more institutionalised these investment principles become, the greater will be the stigma associated with delisting. There is a momentum to the process of affirming the importance of social and environment principles that once may have been overlooked, and that momentum is gathering pace. The UN PRI has signatories across the globe The principles for responsible investment revolve around six commitments on the part of institutional investors, consistent with their fiduciary responsibilities, based on the following statement: As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these Principles may better align investors with broader objectives of society. The UN PRI was originally drafted by a group of the world s largest institutional investors in early 2005, recognising that fund managers can play an active role in encouraging companies to adopt more sustainable practices. The number of signatories globally is now around 900. Broadly, the principles set out how signatory companies can incorporate ESG issues into the investment analysis and decision-making process and promote these issues within the investment community. (Refer to the glossary for the six principles of the UN PRI.) The UN PRI initiative aims to promote the consideration of ESG issues into investment practice and permit a better understanding of the implications of investment decision-making within the wider social environment. The UN PRI provides a platform for incorporating ESG into investment analysis and decision-making processes The UN PRI promotes a company s ability to work within an ESG framework, through processes such as sharing best practice. Signing up to these principles also strengthens an investment company s platform from which it can engage with and influence company management in order to improve decision-making in line with ESG issues. For Threadneedle, adherence to UN PRI means that these ESG principles should be applied consistently across asset classes and investment portfolios. According to the GRI team: By adhering to these principles we should be in a position to enhance the long-term financial returns from our funds, as we gain a greater insight into a company s exposure to ESG risks and rewards. We view ESG analysis

9 Integrating the four pillars of investment 9 as a proxy for management quality, and are convinced that well-governed companies will be better positioned to outperform over time. Our SRI and Governance team therefore continually strives to integrate these principles into Threadneedle s mainstream investment activities. The UK Stewardship Code grew out of a lack of active investor ownership prior to the last recession Corporate governance and stewardship are fundamental to principles of ESG being incorporated into the investment process. For the UK, the standards of corporate governance and stewardship are set out by the UK Corporate Governance Code, the FRC UK Stewardship Code, the OECD Principles of Governance and the EFAMA Code for External Covernance. In the context of asset management, these principles centre around: 1. the public disclosure of a company s commitment to engagement with investee companies as well as how ESG is integrated into the investment process 2. the management of conflicts of interest in relation to company stewardship (see point 1. above) 3. the monitoring of investee companies holistic stock review covering business, financial, corporate governance, and social and environmental drivers these serve as a point of reference for further engagement 4. establishing guidelines concerning the escalation of activities to protect and enhance shareholder value 5. principles concerning acting collectively with other investors where appropriate, including in the area of knowledge transfer 6. policy governing voting and disclosure of voting activity The Stewardship Code developed out of recognition that in the run up to and during the last crisis, institutional investors could have done more in terms of engaging with companies on issues around sustainable financial returns and risk management. There was also a widespread concern about the growth in a short-term investor base, which was hampering effective engagement with companies. The Code was drawn up by the UK s institutional investor community through the Institutional Shareholders Committee. The UK s financial regulator, the Financial Reporting Council (FRC), then adopted the Code and implemented it on a comply or explain basis. The aims of the Code are to help rebuild a critical mass of engaged long-term investors, improve dialogue between companies and investors, and provide more transparency to investment managers clients regarding how they discharge their governance and stewardship responsibilities. The FRC states that the Code aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities by setting out good practice on engagement with investee companies. 6 The FRC recognises that the responsibility for monitoring company performance should not be borne by fund managers alone. The Council explicitly calls on pension fund trustees and other investing institutions to take part in the process either directly or indirectly through mandates given to fund managers. Their actions can have a significant impact on the quality and quantity of engagement with listed companies, assist institutional investors in making an informed decision regarding choice of asset manager, as well as helping asset managers understand the expectations of their institutional client base.

10 10 Integrating the four pillars of investment Enhanced stewardship allows investors to collaborate on governance issues A key problem in corporate governance arises from the asymmetry between the company and the individual investor, with it being all too easy for management to dismiss shareholder concerns as those of a lone voice. Collective action on the part of shareholders has been difficult due to the diverse shareholder base. Moreover, there has not been a culture of shareholder cooperation, other than, perhaps, the type of group action cited at the beginning of this paper, when political activists have bought shares with the explicit intention of acting in concert. The UK Stewardship Code attempts to address the problem of individual shareholder power by improving the ability of institutional investors to collaborate on matters of governance without being accused of acting in concert. Different SRI strategies are pursued across the globe Europe dominates the global SRI market Europe is undoubtedly the most dynamic market for SRI (where national market is defined by the country where the SRI assets are being managed), having two-thirds of total global SRI assets under management, according to Eurosif s bi-annual study. European investor exposure to emerging markets is nearly double that of North American investment. Europeans are much more likely to use corporate governance criteria while North Americans favour negative screening (eg tobacco). Within Europe, France and the UK dominate the SRI market, with both countries tending to use a broad approach to SRI. 7 The high level of SRI in Europe reflects the fact that many investors have applied integration or screening strategies to their portfolios, as indicated by the extent of the broad strategy. Indeed, SRI investment in Europe has nearly doubled over the two years between 2007 and 2009, going from 2.7 trillion in 2007 to 5 trillion by the end of 2009, predominantly linked to the increase in ESG policies by asset-rich institutional investors. Europe dominates global SRI AUM 5,000 4,986 Total SRI ( billion) 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, , United States Canada Australia & NZ Japan Europe Source: Eurosif. European Study Notes: Figures are for different years - United States (2010), Canada (2008), Australia & NZ (2010), Japan (2009) and Europe (2009). Eurosif defines a national market by the country where the SRI assets are being managed.

11 Integrating the four pillars of investment 11 Country / region Total SRI ( billion) Share of world total United States 2, % Canada % Australia & NZ % Japan 4 0.1% Europe 4, % Total 7, % Approaches to SRI differ across European markets Within the core and broad market segments, investors in Europe pursue different strategies, largely reflecting the cultural differences that shape domestic SRI markets. For example, broad strategies (such as engagement and integration) are widely used in the UK and France, both of which stand out as the countries with the highest AUM in the European SRI market. Switzerland, on the other hand, tends to favour a core approach, with best in class and thematic funds dominating the SRI market. In so far as a broad strategy represents the mainstreaming of SRI markets, France, Italy, the UK, Belgium, Poland, the Netherlands and Spain all have over 50% of their SRI AUM in this category, and are thus relatively well developed SRI markets. By contrast, Switzerland, Austria, Germany and Norway have very little broad SRI as a share of total SRI AUM. 8 But in general, the core approach is the most dynamic segment of the SRI market. Country share of core and broad SRI in total AUM CH AT DE NO FI SE DK ES NL EU PL BE UK IT FR 23% 77% 0% 20% 40% 60% 80% 100% % of AUMs Core SRI Broad SRI Source: Eurosif. European SRI Study 2010.

12 12 Integrating the four pillars of investment The burgeoning broad SRI investment market in France dwarfs most other European countries 2,000 1,800 Core SRI Broad SRI Total SRI AUM, at 31 December 2009, billion 1,600 1,400 1,200 1, Austria Baltic States Belgium Denmark Finland France Germany Italy Netherlands Norway Poland Spain Sweden Switzerland UK Source: Eurosif. European SRI Study Note: Eurosif also surveyed Cyprus and Greece for its European SRI Study 2010, but their SRI AUM were found to be negligible. Integration has been the driving force of SRI growth in Europe Integration, the explicit inclusion by asset managers of ESG risk factors into traditional financial analysis, has fired the European SRI market over the last two years, having grown by 191% between 2007 and The strategy of engagement, frequently combined with integration, has risen by 17% in the same period. Integration is the number one strategy in the context of mainstreaming SRI and in Europe represented 2.8 trillion of AUM at the end of France has experienced the fastest growth in integration, where the figure has boomed since 2008, largely due to a small number of large investors adopting this approach. The reason for the growth in the integration approach to SRI is that it is a tangible expression of fiduciary duty, says Eurosif. 9 Over 80% of those represented in Eurosif s European 2010 study indicated that they have a formal integration policy document. However, this approach lacks a consistent and coherent framework, as the practices and depths of the approach vary significantly, with the result that interpretation of integration may vary from one country or asset manager to the next, notes Eurosif. While France appears a particularly dynamic market for ESG, sceptics assert that asset managers using this approach have not yet clearly articulated how ESG criteria are actually being implemented and how well the actual value added of the assets can be measured. As noted by Novethic, a research centre in France on Corporate Social Responsibility (CSR) and SRI, the extra-financial requirements imposed on the assets subject to ESG integration are not as strict as those imposed on SRI funds, and practices can vary widely from one manager to another. 10 The United States has over $3 trillion in SRI AUM Growth in SRI in the US has outstripped that of traditional investment assets. At the start of 2010, professionally managed assets following SRI strategies stood at $3.07 trillion, a rise of more than 380% from $639 billion in 1995 (when the US SIF first conducted a study). Over the same period, the broader universe of assets under professional management increased 260% from $7 trillion to $25.2 trillion. The recent financial crisis has witnessed relatively flat levels of traditional AUM while SRI assets have continued to enjoy healthy growth. From the beginning of 2007

13 Integrating the four pillars of investment 13 to 2010 market indices such as the S&P 500 declined and the broader universe of professionally managed assets increased less than 1%, while SRI AUM increased more than 13%. As a result of this growth, nearly one out of every eight dollars under professional management in the United States today is associated with some strategy of SRI. A number of factors account for the growth of SRI assets The $3.07 trillion SRI assets under management in the US follow at least one of three strategies: the incorporation of environmental, social and governance (ESG) factors into investment analysis and portfolio construction the filing or co-filing of shareholder resolutions on ESG issues deposits or investments in banks, credit unions, venture capital funds and loan funds that have a specific mission of community investing 11 Assets under management linked to SRI strategies have grown more rapidly than the overall investment universe due to a number of factors, including net inflows into existing SRI products, the development of new SRI products and the adoption of SRI strategies by managers and institutions not previously involved in the field. The total assets managed under policies that specifically incorporate ESG criteria into investment analysis and portfolio construction (ESG assets) are valued at $2.51 trillion. Other popular strategies in the US include shareholder advocacy and community investing. Like Europe, the US SRI market is dominated by institutional investors. Sustainable and responsible investing in the US, ($ billion) ESG $162 $529 $1,497 $2,010 $2,143 $1,685 $2,098 $2,512 incorporation Shareholder $473 $736 $922 $897 $448 $703 $739 $1,497 advocacy Community $4 $4 $5 $8 $14 $20 $25 $41.7 investing Overlapping na ($84) ($265) ($592) ($441) ($117) ($151) ($981.18) strategies Total $639 $1,185 $2,159 $2,323 $2,164 $2,290 $2,711 $3,069 Source: Social Investment Forum Foundation. There are several major drivers of SRI growth in the US Over the past decade, SRI growth within US financial markets has been shaped by several key trends: Fund managers are increasingly incorporating ESG factors into their investment analysis, decision-making and portfolio construction, due to demand from institutional and retail investors. Institutions (particularly public funds) are incorporating ESG criteria in part because of legislative mandates. New products and fund styles are driving growth in ESG investment vehicles, especially among ETFs and alternative investment funds such as social venture capital, double- and triple-bottom-line private equity and responsible property funds. 12 Environmentally-themed investment products are increasing in response to investor desire to manage environmental risks and realise opportunities in a range of green technologies.

14 14 Integrating the four pillars of investment Regulatory developments have encouraged investors to take a more considered approach to proxy voting, with shareholder proposals on governance issues often receiving majority support. Legislative and regulatory developments have set higher standards for corporate disclosure on ESG issues and increased corporate accountability to shareholders and other stakeholders. There is growing coordination between institutional investors and money managers on shareholder resolutions and to advance their shareholder advocacy through public statements and other policy initiatives. 13 The United States has the biggest asset management industry in the world, but has quite a different approach to SRI to that of Europe. There are a couple of reasons in particular, for the way the SRI market has developed in the US: US SRI has its origins in faith-based principles (charities and churches which exclude tobacco and pornography, for instance) and it is taking a lot of effort to move the country s mindset forward from this base. The US has a very strict legal definition of fiduciary duty and the litigious culture of the US has stopped many companies from signing up to the UN PRI. Statutory law provides potential legal challenges for firms wanting to sign up to the UN PRI because legal action can relatively easily be taken under the concept of negligence, particularly given that the UN PRI is purposely left fairly vague and open to interpretation. On the other hand, there have been suggestions that asset managers have a legal obligation to exercise prudence by incorporating ESG factors into investment decisions. 14 However, there has recently been some increased focus on the investment principle of integration. In May 2011, two Californian pension fund giants, CalPERS (California Public Employees Retirement System), the largest US pension fund, valued at $236 billion, and CalSTRS (California State Teachers Retirement System), a $152.9 billion fund, both committed to integrating ESG principles into their investment decision-making processes. This reflects our belief that a deep understanding of sustainability issues is critical in achieving successful long-term investments results, noted the CalPERS CEO, Anne Stausboll. She went on to emphasise the important relationship between government policy and industry action: Policies can point out a direction, but only companies and investors can take us to our desired destination of a truly sustainable economy. 15 Malaysia has a large number of faith-based SRI funds SRI assets under management data is not well-published in the case of Asia, except for Japan (as given at the beginning of this chapter) and Korea, where funds with an SRI overlay or theme amounted to $2.4 billion as at June ASrIA, the social investment forum for Asia, publishes details of the number of thematic funds, by country. Strikingly, Malaysia has the most funds, and they are all faith-based. According to the constitution of Malaysia, all ethnic Malays are considered Muslim, with around two-thirds of the population in Malaysia actively practising Islam. Not surprisingly, therefore, Malaysia has a relatively high number of Islamic Shariah funds. Japan has the next highest number of funds, and in this case, the level of AUM is valued around 4 billion. (Figures from Japan do not differentiate between core and broad SRI.) This year, RENGO, a powerful Japanese union, issued formal guidelines to pension funds and managers to adopt ESG principles an indication of a similar trend to those in Europe and North America. Despite their phenomenal rate of economic development, the two Asian BRIC countries, China and India, each have only three SRI funds.

15 Integrating the four pillars of investment 15 Malaysia dominates the number of SRI funds in Asia Public Funds Private Equity SRI pension mandates Faith-based Total country China Hong Kong Japan Korea Taiwan Singapore Malaysia Indonesia India Thailand New Zealand Vietnam Total segment Source: ASrIA. Challenges to the future growth of ESG There is little doubt that that ESG integration has come a long way in its development, particularly in the recent past. Incorporating ESG principles into investment decisionmaking at an international level is important for several interrelated reasons: Client demand (from institutional and retail investors) is driving the advance of ESG and as client demand increases and the industry responds, such demand becomes an expectation or industry norm. Media coverage of environmental disasters fuels client demand for investment that takes into account ESG principles. The media effect is particularly important in the light of environmental disasters such as the BP oil crisis in the Gulf of Mexico in 2010 and the damage to the Fukushima nuclear plant following the devastating earthquake in Japan in March The repeated broadcast of such events acts as a powerful reminder to investors to incorporate ESG principles into their decision-making process. Asset managers and other industry participants are obliged to incorporate stewardship and other related ESG principles into their investment processes. An increasing globalised investment market means that principles of ESG will also be expected by those investing in emerging markets. Recession has refocused both clients and the asset management industry on developing and ensuring more effective risk management and transparency in business practices. There is greater recognition that an SRI overlay to conventional research and analysis adds value to an investment portfolio. It is also widely believed that emerging and frontier markets may hold unexplored value from these themes. Expansion of the ESG market will undoubtedly continue, but there are some fundamental issues that need to be addressed for ESG to become fully mainstream at an international level. These include: Growth in client demand for ESG integration The value proposition Education, resources and development of the market research process

16 16 Integrating the four pillars of investment Institutional investors are driving client demand for ESG integration ESG principles meet the demand for taking into account corporate governance issues in investment decision-making. In its European SRI Study 2010, Eurosif identified the key drivers of SRI demand over the next three years. Two of the top four influences are the changing client demand for SRI. 1. Demand from institutional investors is considered the most important driver for SRI, with risk management being an increasingly important concern for these investors. Asset manager feedback is positive but they also request more detailed assessments and transparent processes around how they appoint these integration investors. However, there is still a concern that asset managers are not sufficiently challenged on their integration processes when the asset owners engage with asset managers. The process remains a little at the box ticking stage. 2. International initiatives (eg UN PRI) are deemed the second key influence on the SRI market. Signatories to the PRI number some 900, representing over $2 trillion worth of assets, indicating the importance of these principles to global investment. 3. External pressure from NGOs, media and unions is ranked third. 4. Retail investor demand is the fourth most important driver of SRI. The recession and global environmental issues are two of the most important factors impacting on individuals and their financial decision-making. Eurosif undertakes regular surveys of high net worth individuals (HNWIs) and estimates that sustainable investments represent about 11% of HNWIs portfolios. These investments are estimated to make up 15% of portfolios by 2015, representing some 1.2 trillion. 17 The most recent studies in both the United States and Europe stress the importance of both institutional and retail client demand in the growth of AUM that incorporates ESG principles. A 2010 study by Aberdeen Asset Management concluded that ESG is increasingly a focus by institutional investors. Two-thirds of the 200 pension funds researched had an ESG policy in place. In 2010, 70% of requests for proposal (RFPs) in Europe required an ESG integration process, through the UN PRI. This percentage is only expected to rise, indicating that SRI is altering the investment landscape. External pressures to increase stewardship have come from both regulatory and political developments. There is a real momentum at a European level to improve stewardship throughout the investment chain and many believe that a key way to do this is to target asset owners and the way they select and engage with their asset managers. It remains unclear whether on-going consultations on the matter of stewardship will result in a principles-based approach or regulatory measures. The value proposition how ESG integration adds value to the portfolio A fundamental question throughout the development of mainstream ESG integration has been how it adds value to the actual portfolio and investment process. Some evidence suggests that material ESG factors, when integrated into investment analysis and decision-making, may offer investors long-term performance advantages. Investment methodologies embrace ESG or sustainability considerations as a means to help identify companies with superior business models which in some form translate to an underlying financial value. ESG factors may offer portfolio managers added insight into the quality of a company s management, culture, risk profile and other characteristics. By taking advantage of the increased level of scrutiny associated with ESG analysis, investors can identify companies that deal more effectively with a range of corporate issues that impact on risk and reward, and therefore have a positive impact on financial performance. Successfully conveying the message and demonstrating that incorporating ESG principles into investment research and analysis adds real value to an investment portfolio is key to combatting ongoing scepticism about SRI.

17 Integrating the four pillars of investment 17 At least part of the reason for this added value is that the approach necessitates a broader consideration of risk and reward factors that lie outside traditional analytical metrics. The result is more informed investment decisions on the part of fund managers, who benefit from a fuller knowledge of a company before it is included in a portfolio. Apart from the opportunity to enhance the fundamental analysis, integration of ESG issues may also facilitate better diversification and overall risk management of the portfolio. The potential impact on financial performance of focusing on ESG principles is captured in the graphic below. e Focus Resource management and pollution prevention Reduced emissions and climate impact Environmental reporting / disclosure Financial Impact Avoid or minimise environmental liabilities Lower costs / increase profitability through energy and other efficiencies Reduce regulatory, litigation and reputational risk Indicator of well-governed company s g Workplace Diversity Health and safety Labour / management relations Human rights Product Integrity Safety Product quality Emerging technology issues Community Impact Community relations Responsible lending Corporate philanthropy Executive compensation Board accountability Shareholder rights Reporting and disclosure Workplace Improve productivity and morale Reduce turnover and absenteeism Openness to new ideas and innovation Reduce potential for litigation and reputational risk Product Integrity Create brand loyalty Increase sales based on products safety and excellence Reduce potential for litigation Reduce reputational risk Community Impact Improve brand loyalty Protect license to operate Align interests of shareowners and management Avoid unpleasant financial surprises or blow-ups Reduce reputational risk Source: ESG Managers The press has its own scepticism: No new evidence SRI funds create financial value The effect on performance of incorporating ESG principles into investment analysis can be subject to widespread scepticism. Even the financial press can be sceptical of ESG principles governing investment decisions. SRI funds not outperforming Financial Times No new evidence SRI funds create financial value Investment & Pensions SRI Funds did not outperform Pension and Benefits Monitor These were the headlines that a report, The Performance of Socially Responsible Investment and Sustainable Development in France: An Update after the Financial Crisis (published by the Edhec-Risk Institute), engendered in the press. 18 A Canadian SRI analyst, Milla Craig, was concerned about their accuracy, so made a study of the facts herself and concluded that the French report made non-controversial conclusions about SRI funds in the European market. The three main comments, she reported, were as follows: 1. The study confirms Edhec-Risk Institute s previous results on SRI as presented in the 2008 position paper. At this stage it has not been shown that the pure SRI approach on its own creates value in the financial sense of the term.

18 18 Integrating the four pillars of investment 2. This does not mean that extra-financial criteria (ESG factors) should not be taken into account, but they cannot be the only foundation for sound portfolio management. 3. Edhec recommends that SRI be integrated in a more global process whereby the results of fifty years of quantitative research in finance not be abandoned in favour of a solely qualitative approach. As such, an approach that combines stock picking with SRI criteria and a well-diversified portfolio construction methodology is an alternative to pure SRI. Not one of the headlines corresponds to these modest concluding statements. In fact the conclusions support the broad approach to SRI that seeks to incorporate ESG principles into mainstream investment decision-making. This approach precisely aims to guard traditional quantitative research and portfolio construction and provide better performance and better risk management. Craig goes on to put the Edhec report further in perspective by noting the results of a 2009 study by Mercer, published as Shedding light on responsible investment: approaches, returns and impacts. Mercer reviewed 16 academic studies, which Craig pooled with the results of the Edhec report, making 36 studies in total. The evidence in terms of the relationship between ESG factors and financial performance is indicated in the table below. 19 Results of combined studies of Mercer (2009) and Edhec (2010), showing the relationship between ESG factors and financial performance Positive Neutral positive Neutral Negative neutral Negative Total studies No. of studies More integration between SRI and traditional portfolio analysis will ultimately combat scepticism as investors benefit from the superior returns of better-governed companies. Asset managers are in a position to influence company management At the heart of the market s approach to integrating SRI into the processes of research and investment is the belief that well-governed companies are better positioned to outperform over time. This philosophy relates to companies which take into account risks and opportunities in relation to environmental, social and governance issues to help create shareholder value. Asset managers that are signatories to the UN PRI have a strong platform to influence company managements in relation to improving their ESG performance. This enables asset managers to capitalise on any opportunities arising from best practices. It must be borne in mind that asset managers have a fiduciary duty to maximise returns for their clients within their own risk and return criteria (as well as any other investment principles the client specifies). The ESG approaches and products offered reflect the profile of the asset owner. Threadneedle has its own approach to the principles of the UN PRI, which are in keeping with a broad strategy to SRI. Like many other asset managers, Threadneedle emphasises SRI overlay, integrating its sustainability analysis into the research and investment process. The company believes that adherence to the UN PRI means that these principles should be applied consistently across asset classes and investment portfolios.