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February 2017

ESG deconstructed

There's much more to responsible investing than avoiding 'sin' stocks.

Delivering superior returns at the right price is no longer enough. Many investors now want proof that their asset managers are responsible stewards of capital who incorporate environmental, social, and corporate governance (ESG) considerations into the investment process. Simply put, ESG is no longer a niche area of investment – it is becoming a basic requirement. 

The benefits of responsible investment go far beyond an ethical halo. Mercer’s research over the past decade shows that ESG principles can help frame risk and return from a broader perspective and to future-proof returns over a long-term horizon.

Taking the high road – with a choice of routes

Most of the questions from Mercer’s clients centre around how they can – or should – tackle ESG in practice. Broadly speaking, there are four distinct approaches. The first is screening. This is the oldest and best-known form of responsible investment – the avoidance of potentially controversial products like tobacco, weapons, gambling and alcohol.  Charities, foundations and religious faith groups are among the investors who tend to favour this approach and take it very seriously.
responsible investment
A range of implementation approaches
ESG responsible investment a range of implementation approaches

* Common approaches for pension funds. Source: Mercer.

Other institutional investors, such as pension schemes, are more likely to focus on stewardship – or the extent to which their investment managers engage with the companies they invest in to drive positive change – and/or on the integration of material ESG consideration in decision-making and investment analysis.

The fourth approach is arguably the most direct, and can come without the addition of moral or any other dimensions. It centres on investing in sustainability-related themes, such as low carbon energy, health or water, which have a long-term potential to deliver attractive returns.
There is a growing number of interesting investment strategies within this area and they are no longer just limited to listed stocks but include infrastructure, private equity and fixed income. Clean and renewable energy in particular is now attracting a lot of attention given institutional investors’ growing desire to “decarbonise” their portfolios.

Assessing ESG integration

The Mercer assigns strategy level ESG ratings – from ESG1 (the highest) to ESG4 (the lowest) – to approximately 5,500 individual investment strategies. These ratings capture, qualitatively, how ESG issues are incorporated across four factors: idea generation, portfolio construction, active ownership and business management (firm wide commitment). The ratings reward action and intent rather than, for example, signing up to an initiative or buying external research and doing little with it.

The benefits of responsible investment go far beyond an ethical halo.

The investment firms that are leading on ESG integration tend to exhibit behaviours including: establishing dedicated ESG resources and expertise; making efforts to build ESG into valuation models; and developing thoughtful voting and engagement processes, as well as strong firm-wide commitment.

Traditionally, a lot of the top-scoring strategies (those rated ESG1) have tended to be thematic i.e. those with a specific or explicit ESG focus. Increasingly, however, we are seeing more traditional managers embrace ESG integration within their standard strategies. For example, in the last four or five years we have seen significant progress in the ESG integration efforts of managers, reflecting growing engagement by the industry. This is reflected in the shift in the distribution of the Mercer ESG ratings, away from ESG4 and towards ESG3 and ESG2 ratings in particular. However, there is still a long way to go – particularly in fixed income.

Bracing for climate change

Climate change - an issue that today is never far from the front page – is a good example of both the opportunities that an ESG approach can present and the risks that it can help avoid. On the face of it, this seems like a crusade more suited to politicians than pension schemes.
implementing sustainability
Key themes
ESG implementing sustainability key themes

Source: Mercer

So why should investors care? The policy measures required to address climate change – which will be felt sooner than the physical impacts – will undoubtedly create material economic impacts, and by extension will be felt by investors via their portfolios.

Under the Paris Agreement, 196 nations pledged to keep global warming to no more than two degrees Celcius between now and 2100 – a threshold seen as the tipping point beyond which climate change could have serious consequences for our planet. Given that the world population is projected to grow from 7 billion to 10 or even 12 billion in that time – and more people implies greater energy and material needs – this clearly presents a big challenge in terms of stopping or even reducing CO2 emissions. To meet the 2DC target will require a lot of new policies and regulations, alongside new and improved (i.e. lower carbon) ways of generating energy. Mercer’s research finds that investment returns will be impacted under two, three and four degree scenarios – and that asset class and sector level impacts are particularly important for investors to understand.

For example, under a 2DC scenario, developed equities in general – and Energy and Utility sectors in particular – are likely to suffer because of the significant restrictions that will be placed on “high carbon” industries. Emerging market equities, on the other hand, are likely to benefit from injections of capital to help them transition to a lower carbon economy. For real assets like infrastructure and property, incentives will be needed to make new assets “green” from the outset and to “decarbonise” existing assets.

It’s not all about risk, though. There are opportunities to make money from solving the challenges created by climate change. We are seeing this through growing interest in sustainability-themed strategies, but also through a quiet shift of focus in many traditional industries such as autos and energy.