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The Irresistible Momentum For Sustainable Investment

ESG   |   Economics   |   Regulations

By David Maywald, CFA GAICD  |  June 11, 2020

Sustainable investment is one of the few long-term growth stories in finance and there’s much more growth to come. There are attractive opportunities for investors, entrepreneurs, start-ups, service providers and researchers. So get on board and be a part of this positive change.

The finance sector and companies are embracing the importance of Environment, Social and Governance (ESG) issues. ESG indices and funds have been outperforming their peers, with lower risk. Inflows to sustainable funds reached new record highs during 2019, during the first quarter of 2020, and during the month of April.

“It was clear that 2019 marked a turning point in incorporating ESG factors into mainstream investing,” according to Morrow Sodali’s 2020 Institutional Investor Survey.

The Drivers of Sustainable Investment Have Become Irresistible

Sustainable investment aligns with the values and interests of our members and end-customers. It’s the right thing to do for the health of our planet and communities.

Conventional economics has been seriously damaging the environment and our society for decades. Every parent, consumer and investor knows it; fossil fuel promoters and ESG laggards especially. Poor disclosure, free pollution and misaligned remuneration are part of the problem. But sustainable investment and renewable energy are an essential part of the solution.

Renewables and corporate responsibility are highly popular with voters. People are fed up with being lied to (spun, misled, and manipulated), being ripped-off, and with large bonuses for short-term profits. We all bear the externality costs from unsustainable corporate behavior. Management, boards, politicians, and regulators have all been complicit; things have to change.

The irresistible momentum for sustainable investment is about millions of people who move their money and work together for positive change, which expands to hundreds of millions of people and eventually to billions of people. Sustainable finance is also about the new innovative businesses that serve these customers as well as established businesses having to catch up to where the market has moved.

“ESG investing has grown significantly over the past decade and has become an essential part of any investment process… One investment theme that will dominate the 2020s will be ESG investing. Both public companies and asset managers have seen increasing demand from investors, regulators and peers to report/adopt ESG as part of their process. Sustainable investment funds continued to grow with net inflows in 2019 almost four times those seen in 2018.” Alvin Chao (Analyst, Quantitative Strategy at Macquarie Group)

Rewards and penalties will become sharper in the future with remuneration linked to ESG/longer-term/qualitative outcomes. There will be a greater dispersion of cost of capital, from the best to worst performers.

Momentum Behind the Business Case for Sustainability

All of the pieces are falling into place, to support the continued growth of sustainable investments. There is an ever-expanding range of investment options with thousands of funds spanning all asset classes. Indices such as the 30-year-old MSCI KLD 400 Social Index have been outperforming their generic peers. Sustainable funds have seen unprecedented inflows and have also outperformed with lower volatility. ESG ratings are distilling valuable signals about long-term corporate behavior, from the background noise of short-term news flow.

US Sustainable Funds Monthly Flows

Since 2006, the Principles for Responsible Investment (PRI) has grown to 3,108 signatories with U.S. $103 trillion in assets under management. This includes 532 asset owners who sit at the apex of the investment industry. Asset owners and their members have long-term horizons, but their agents often have short-term horizons. These agents include employees, advisors, fund managers, asset consultants, portfolio investment holdings, and executive management teams. When these agents don’t bear the environmental or social costs of their actions, they will misallocate resources. Eternal vigilance is therefore required, which is a key element of the value-add from sustainable investment.

Green Recovery Boosts Short-Term Jobs and Lowers Long-Term Costs

Our leaders are focused on recovering from the COVID-19 recession. Stimulus must go towards businesses, projects and jobs that have a long-term future. An emphasis on sustainability will build resilience, while doubling down on fossil fuels and other depleting industries will only fail (and waste taxpayer’s money).

A survey of G-20 officials and central bankers shows strong support for climate-friendly measures (green projects create more jobs, they deliver a higher short-term return, and they lead to long-term cost savings). The European Commission president is putting their Green Deal at the center of the recovery plan of the European Union (EU), pushed along by a very broad “green recovery alliance.” One-quarter of the total EU spending (€1.1 trillion budget plus €750 billion recovery plan) will go to climate initiatives.

Seize the moment

Source: The Economist Newspaper Limited May 2020

Fossil fuel divestment has attracted U.S. $14 trillion of commitments, compared to the softer approach of active engagement with energy producers. These divestment commitments span 1,237 institutions (as well as 58,000 individuals). 117 banks, insurers, and export credit agencies have restricted financing for fossil fuels according to the Institute for Energy Economics & Financial Analysis.

Voluntary Disclosures and Commitments Have Increasingly Become Mandatory

The EU is deploying all policy levers to deliver its Green Deal (fiscal, monetary, regulatory) with leadership across disclosure, carbon, investment stewardship, and taxonomy. They have the most advanced and abundant suite of ESG regulatory measures.

“The scale of the ESG regulatory phenomenon is such that it is on the cusp of modifying the traditional categories of financial regulation (Prudential Rules, Conduct Rules, Financial Crime Rules, Payments and Market Infrastructure Rules). With the current pipeline of regulations and proposed initiatives, it seems that ESG will inexorably become the fifth pillar of financial regulation.” Barrie Ingman (Financial Services Regulatory Lawyer, FactSet).

Development of the EU Sustainable Finance Taxonomy is following a similar path to the Markets in Financial Instruments Directive (which has had a transformative effect, both on EU capital markets and around the world). MiFID was implemented in 2007, then tightened and broadened in 2014. The unbundling of investment firm research costs from trade execution became effective two years ago. Since that time 70% of investment managers have implemented a global policy of unbundling, according to a Liquidnet poll (despite the rules only covering the EU)...it makes sense to anticipate that the taxonomy will be widely applied outside of the EU, that it becomes more rigorously applied over time, and that other countries will follow the lead of Europe.

The pace of new sustainable finance rule-making (both hard and soft) has been increasing, according to ECOFACT and the Institute of International Finance (IIF):

Sustainable Finance Regulatory Developments

Source: Institute of International Finance and Policy Outlook (ECOFACT), which is a continuously updated research package focusing on hard and soft law initiatives pertaining to sustainable finance and corporate responsibility issues. For further information on the Policy Outlook, please contact policy@ecofact.com. The chart shows regulatory developments across the broad range of sustainable finance measures relating to the SDGs, i.e., not only focused on climate-related topics. Regulatory developments are any relevant policy development such as submission of an initial regulatory proposal, consultation periods, parliamentary debates, and entry into force of a given law.

Applying the Sustainable Investment Approaches in Practice

The definitions published in the 2012 Global Sustainable Investment Review have become the global standard:

  • Negative/Exclusionary Screening: is the most popular approach (U.S. $20 trillion in 2018), it reduces the investible universe based on sustainability criteria; this approach encompasses divestment
  • Positive/Best-in-class Screening: targets the issuers who are outperforming their peers; it’s well-suited to the deep/liquid public markets for equity and debt
  • Norms-based Screening: compares investment options against the minimum standards of business practice based on international norms such as those issued by the OECD, ILO, UN, and UNICEF; it is prevalent in Europe and Canada
  • ESG Integration: is the second-largest approach (U.S. $18 trillion), it aims to systematically include ESG in the investment process (but in practice there’s a complete spectrum from shallow to deep integration, which varies enormously across Asset Owners and Investment Managers); integration is becoming deeper with subsequent iterations, making better use of third-party research/disclosure/ESG ratings
  • Sustainability Themed Investing: specifically narrows the portfolio such as focusing on clean energy, sustainable agriculture, or green technology; this approach is dominated by the United States
  • Impact/Community Investing: is the least popular strategy; it explicitly aims to solve social and environmental problems
  • Corporate Engagement and Shareholder Action: active ownership has a wide range of actions from dialogue to voting to proposing shareholder resolutions; increasingly there is active two-way engagement between investors and companies

The Handbook on Sustainable Investments from the Swiss Sustainable Finance and CFA Institute Research Foundation is an excellent resource. It mentions some theory, but mostly details the implementation of the seven approaches in practice.

Relevance of Different Approaches for Different Asset Classes

Source: Swiss Sustainable Finance and CFA Institute, from 2017. This table takes into consideration whether products in the combinations specified are available in the market. Passive investments are actually “semi-passive” as they mostly incorporate an active selection based on sustainability criteria, which is then modeled in a passively managed product (by­ its very nature, this product deviates from traditional indices). Other alternatives include Hedge funds, commodity investments, and private bonds (the most commonly used instrument in microfinance, which is a form of impact investing). Corporate bond thematic investments are possible through Green Bonds issued by companies or governments. Thematic commodity investments include gold with a sustainability certificate.

Conclusion

The finance sector became disconnected from the ordinary lives of people, society and our environment between the 1980s and the 2010s. However, the values and interests of end-customers will ensure a re-connection. The ecosystem for sustainable investment continues to evolve rapidly, but it is complete enough to facilitate fast growth and expansion. The outlook for sustainable investment is robust with many exciting opportunities to grow.

 

The full story of The Irresistible Momentum for Sustainable Investment, along with thoughtful Q&A, can be seen here.

 

This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet Research Systems Inc. FactSet makes no guarantees as to the accurateness, quality, or completeness of the information and will not be responsible for any errors, omissions, inaccuracies of the information, or any reader’s reliance on the information.

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David Maywald, CFA GAICD

Board Member and Expert Contributor

During a two-decade career at four Investment Managers, David Maywald became an experienced Portfolio Manager and Research Analyst. As a founding employee of RARE Infrastructure, he led the Sustainable Investment efforts and collaboration on ESG initiatives. David personally wrote the first case study of ESG Integration for Global Listed Infrastructure, in September 2011. RARE received a score of A+ in the Strategy and Governance assessment from PRI last year. David is passionate about his family, cycling, renewables, sustainability and driving positive change. His governance experience includes the community-run solar farm SolarShare, and cycling advocacy organisation Bicycle NSW. He is currently contributing to the development of a Sustainable Finance Roadmap as an Expert, which is part of the Australian Sustainable Finance Initiative. David is keen to work with Asset Owners who are deepening their incorporation of sustainability and responsible investment.

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