ESG

ESG integration continues at pace with environmental factors to the fore

ESG adoption continues to gain traction amongst both sovereigns and central banks as it becomes clearer how to derive value from its application; ‘E’ is becoming the focus of sovereign segment Environmental, Social and Governance investing (ESG).

ESG

In our third theme we find Environmental, Social and Governance (ESG) integration continuing at pace, rapidly so with supporters. This is just two years after we highlighted a split in asset owners’ perspectives, with a small but dedicated group of ESG supporters adopting and integrating ESG principles, and a large group of non-supporters seeking more certainty before considering its application.

This group of supporters have considerably developed its thinking, moving beyond early efforts often centred on relatively simple screening, to more sophisticated and specific forms of integration. Many have intensified their focus on ESG, added or deepened dedicated ESG teams, and have overcome initial scepticism (in some cases) to integrate their interpretation of ESG into broader investment policies and processes (Figure 5).

Figure 5. Respondents with a specific ESG policy at the organisational level (% citations)

Figure 5. Respondents with a specific ESG policy at the organisational level (% citations) Figure 5. Respondents with a specific ESG policy at the organisational level (% citations)

Sample size: 113; Central banks: 53; Sovereign funds: 60.

While ESG is spreading across asset classes (Figure 6), investors continue to find constraints to implementation, even in equity portfolios – the issues raised in 2017 relating to lack of definitions and quality data remain for the most part unresolved. These issues were often exacerbated when extending ESG principles to fixed income, with sovereigns citing challenges specific to fixed income integration such as difficulties for bondholders in engagement, limited coverage and application by ratings agencies, limited product coverage and valuation concerns in green bonds.

Figure 6. Asset classes believed to be viable for ESG implementation by region, Sovereigns only (% citations)

Figure 6. Asset classes believed to be viable for ESG implementation by region, Sovereigns only (% citations) Figure 6. Asset classes believed to be viable for ESG implementation by region, Sovereigns only (% citations)

Sample size: West: 19; Asia: 10; Middle East: 6; Emerging markets: 4.

There is clear progress in ESG. In 2019, we find that leading ESG adopters increasingly see “G” factors as assumed or complete. Given the definitional issues, it has been common practice for asset owners to commence their ESG journey with a focus on “G” issues. Governance issues such as board composition and the ability to flag controversies often made the G easiest to define and measure in a consistent manner, as well as offering some evidence of return or risk benefits.

ESG leaders have now started to anchor their policy framework around “E” environmental factors (Figure 7), including the potential to deploy capital to projects which advance initiatives such as de-carbonisation.

Social factors are recognised as important but most difficult to define. Leading adopters continue to develop and refine their thinking in this area – “S” as the risk of loss of social licence being an example. Respondents see the value of understanding social issues under the umbrella term of ESG, and some sovereigns have implemented social initiatives internally as a demonstration of commitment to ESG values. However, in comparison to other ESG factors, social variables have yet to become a practicable means of evaluating risk / return.

Figure 7. Importance of ESG elements, Sovereigns only (average score out of 10)

Figure 7. Importance of ESG elements, Sovereigns only (average score out of 10) Figure 7. Importance of ESG elements, Sovereigns only (average score out of 10)

Sample size: 2017: 23; 2019: 39. Rating on a scale of 1 to 10 (2017) and 0 to 10 (2019) where 10 is the most important.