ESG principles and standards
The development of common standards for ESG investing is still a work in progress, making it vital for investors to look “beyond the ratings" when building and executing an ESG strategy.
The UN Principles for Responsible Investment (PRI) have become the basis for the ESG frameworks and philosophies that many major asset managers and investors use to guide their ethical investing strategies. These six principles are “a voluntary and aspirational set of investment principles that offer a menu of possible actions for incorporating ESG issues into investment practice”.
Signatories to the PRI commit to following six broad principles. Three of these directly relate to how the signatories implement ESG issues in the assets they manage or own:
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
While the other three are intended to promote the wider adoption of ESG investing:
- Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
- Principle 6: We will each report on our activities and progress towards implementing the Principles.
Exactly how each principle should be implemented is down to the signatories, but the PRI provides guidance on possible actions, which range from the development of ESG-related tools and metrics to inform analysis and decisions to the adoption of formal policies on how the shareholder will vote on ESG-related resolutions.
The benefits and limits of ESG disclosures
While ESG investing sounds simple in theory, analysing whether a company makes a positive or negative contribution on many of the key ESG factors is not always straightforward. The kind of financial reports that companies have always provided will often give little insight into the ESG implications of their operations.
Various private companies have developed their own ESG criteria and ESG ratings to fill this information gap. For example, index providers such as MSCI, S&P Dow Jones and FTSE Russell have developed a range of ESG data, ratings and reports that are used for analysing the ESG performance of individual companies, assessing the ESG impact of portfolios and constructing ESG indexes and other benchmarks.
The growing availability of ESG data is helping to drive the expansion of ESG investing and helping to integrate ESG into the investment process. However, ESG ratings for the same company can differ significantly between two providers. This suggests that the future development of global ESG reporting and analysis standards will be vital to ensure that ESG investing achieves its full potential for integrating ESG issues into global capital markets.
While the existence of such ESG ratings and scores is critical for financial institutions to offer ESG investment solutions, the use of them presents a number of challenges:
- Lack of common standards means that the choice of ratings provider may influence investment decisions
- A weak ESG score is not necessarily a reason to exclude an investment if the company is making better progress at improving its standards or actions than other businesses in its sector
- A high ESG score at the present time does not necessarily equate to a business that is sustainable over the long term
These challenges show that investors need to look beyond the ratings and analyse more closely how companies are performing against selected ESG themes.
The most popular ESG strategies
There are a vast number of ways in which investors can implement ESG strategies and work towards ESG goals. These include screening investments based on ESG factors such as the ones listed above; the use of investment vehicles designed to achieve specific ESG objectives, such as “green bonds”; making direct investments in companies that aim to have a positive impact on particular ESG issues; and engaging with companies with the express intention of pushing management to improve ESG performance.
Three of the most popular strategies are:
- “ESG integration” – which involves systematically incorporating ESG factors into financial analysis as part of the process of assessing a company’s strengths, weaknesses and risks – has grown rapidly in recent years and is now the largest strategy globally.
- “Negative screening” or “exclusionary screening” – under which investors avoid companies that do not meet their environmental, social or governance criteria – is the longest-running approach to ESG investing and remains the second-largest area today.
- “Corporate engagement” and “shareholder action” which covers a broad range of scenarios in which investors try to bring about positive change at investee companies.
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