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ESG and FDI: A glossary

Environmental, social and governance issues are more important than ever for investors, but uncertainty surrounds much of the terminology linked to the topic.

ESG education SDGs
‘Quality education’ is one of the UN’s Sustainable Development Goals. (Photo by Wikus de Wet/AFP via Getty Images)

Embracing environmental, social and governance (ESG) criteria is becoming a necessity for investors around the globe, as they see it as a way to safeguard their businesses without having to compromise on returns.

Indeed, a recent study by Morningstar found that the majority of ESG funds tend to perform better than their conventional peers. The study, which analysed 745 Europe-based sustainable funds over a 10-year period, revealed that about 60% of the sustainable funds generate higher returns than their traditional peers.

The fact that ESG investments tend to perform well both in the short and long term is a key factor for longer-term investors such as pension funds and insurance companies.

Clearing up confusion

Despite this popularity, 56% of ESG adopters say there is a lack of clarity over its terminology, according to a survey of institutional investors by Longitude Research in association with State Street Global Advisors.

Sophisticated larger investors tend to be more familiar with the ESG investing, however, while smaller investors are more likely to struggle to understand the related terminology or identify the differences between responsible investing and sustainable investing, or impact investing and ethical investing, among others.

Some of these terms are used interchangeably but, as more investors are looking to embrace ESG, there is a focus on achieving standardisation with regards to what these terms mean.

This article will shed light on these terms to help investors who want to adopt the best strategy for their ESG investments. For some, ESG investing is a way of avoiding risks and protecting investments, while others are looking to adopt ESG to increase value. Others still are looking to generate both impact and returns. Investors see ESG as a value-adding indicator, as it assists them in mitigating risks as well as increasing financial returns.

The E, the S and the G

Environmental, social and governance is a set of criteria that investors use in a bid to screen investments. The term takes in a wider group of risks and opportunities that are significant indicators of the performance and competitiveness of an organisation. It also takes into consideration material factors and incorporates them into the decision-making process.

ESG is divided into three elements – the E, the S and the G – where each represents a wider group of areas.

The E screens investments for environmental risks, with key topics including climate change, greenhouse gas emission management, waste management and water depletion. Supply chains are another issue as they can cause deforestation as a result of the demand for new land for livestock, among other factors.

The S element focuses on the social aspect of investments, exploring risks and opportunities related to occupational health and safety, product safety, employee relations, the management of human capital, human rights, as well as access to products and services.

The last element, the G, is related to governance. Among the key indicators that investors are screening companies for here are the board’s structure, its diversity, succession planning for senior roles and the board, compensation policy, anti-corruption measures and tax responsibility.

The increase in demand for ESG investments has run alongside the growth of membership of the Principles of Responsible Investment (PRI) organisation, an investor initiative that is run in partnership with the UN Environment Programme and the UN Global Compact.

According to its website, the PRI “works to understand the investment implications of ESG factors and support its international network of investor signatories in incorporating these factors into their investment and ownership decisions. The PRI acts in the long-term interests of its signatories, of the financial markets and economies in which they operate, and ultimately of the environment and society as a whole.”

Among the PRI’s principles are that signatories will incorporate ESG issues into investment analyses and decision-making processes as well as into ownership policies and practices. Others include that they will search for disclosure on ESG issues, promote acceptance and implementation of the principles, and that they will report on their activities in regards to implementing the principles.

Responsible investment

Responsible investment takes into consideration ESG factors as part of its process in a bid to mitigate risk, as well as enhance risk-adjusted financial returns.

This kind of investment also seeks to “incorporate ESG factors in investment decisions and active ownership”, according to the PRI.

Impact investing

Impact investing refers to investments that generate measurable social or environmental impact, along with financial returns. Impact investments are made in several sectors, with some of the more prominent being renewable energy, affordable housing and healthcare. The investments are carried out by both companies and funds.

While in 2020 impact investing offers a combination of healthy returns and measurable impact, in the past it has been used to describe investors who would trade off financial returns for measurable impact.

Impact investing is often aligned with the UN’s Sustainable Development Goals (SDGs), with a 2017 Global Impact Investing Network report finding that more than 50% of impact investments have used SDGs to measure at least some of their performance.

SDGs

The SDGs were established by the UN General Assembly in 2015 and form part of the 2030 Agenda for Sustainable Development. The 17 goals are designed to be a “blueprint to achieve a better and more sustainable future for all”, with the intention of them all being reached by 2030.

The goals consist of:

• No poverty.

• Zero hunger.

• Good health and well-being.

• Quality education.

• Gender equality.

• Clean water and sanitation.

• Affordable and clean energy.

• Decent work and economic growth.

• Build resilient infrastructure, promote inclusive and sustainable industrialisation, and foster innovation.

• Reduced inequalities.

• Sustainable cities and communities.

• Responsible consumption and production.

• Climate action.

• Conserve and sustainably use marine resources.

• Protect, restore and promote sustainable use of terrestrial ecosystems.

• Peace, justice and strong institutions.

• Partnerships for the goals.

However, achieving all 17 goals on a global level by the 2030 deadline is an ambitious target. More developed countries are generally closer to achieving the goals, or in some cases have already reached them.

On top of this, the Covid-19 pandemic has further set back the economies of developing countries, as foreign investors are either considering moving their investments to countries closer to their destination markets, or they might exclude some of the developing countries from their investment plans as they look to build resilience in regards to their global footprint.

As a result, this could negatively impact these countries’ chances of achieving the SDGs, as FDI revenues play a part in funding their efforts.

Socially responsible investment

Socially responsible investment (SRI) involves screening companies in a bid to help investors make a decision about whether or not to invest in them. SRI takes into account social and environmental indicators, alongside any likely financial return.

Through this screening, investors can identify the ‘negatives’ that would see them exclude from their portfolios investments that are not in line with their values, which may involve alcohol, tobacco, weapons, etc. However, investors can also do a positive screening to focus on areas that match with their ESG ethos.

Ethical investment

Ethical investment, a sub-sector of SRI, refers to selecting investments depending on ethical or moral values.

This means that an investor excludes companies that operate in sectors considered to be unethical or conflicting with international agreements or declarations, such as the Universal Declaration of Human Rights.

Common exclusions include companies linked to alcohol, weapons, tobacco and pornography, among others areas. Other exclusions can be related to religion, such as companies that are not aligned with sharia law.

Sustainable investing

Sustainable investing refers to the strategy of selecting investments that focus on the long-term sustainability of society as well as of the environment.

Sustainable investment has a similar approach to responsible investing, as it uses ESG to reduce risks. However, it goes one step further by backing investments that look to protect the environment, such as those enabling a transition to a low-carbon economy.

Thematic investment

Thematic investing is the strategy of selecting investments that fall under a particular theme or trend. This practice is not limited to investments focusing on embracing ESG criteria.

Thematic investing is considered a type of positive screening, as it concerns investments in selected areas with links to ESG such as healthcare, board diversity, equality, water distribution, climate change and clean tech. In regards to healthcare, an investor opting for thematic investments in this area would be interested in hospitals, nursing homes and pharmaceuticals, among others.

Trends to watch

With Covid-19 creating disruptions among most industries across the world, embracing more rigorous ESG policies may emerge as a strategy for investors to protect their investments under the current circumstances.

Indeed, ESG has emerged as “more of a focus/more important” as a result of the Covid-19 pandemic for 23% of respondents to a BNP Paribas Asset Management survey about the importance of ESG criteria for investors in the Covid-19 environment, which was conducted by Greenwich Associates.

The study, which was conducted among institutional investors and intermediary distributors during June 2020, also revealed that there was a surge in how important the social part of ‘ESG’ was considered in the early stages of the Covid-19 crisis. The data showed that the importance of social criteria increased by 20 percentage points from before the crisis, reducing the gap on environmental and governance factors.

Apart from Covid-19, other trends that are set to shape investors’ approach towards ESG include the rising requirements for disclosure of climate change-related indicators , but also changes to regulations.

Other emerging themes include technological change and disruption. Automation offers companies a chance to reduce their costs, but this is resulting in increasing fears about job cuts. Also, fears over cyberattacks have increased as working from home becomes more popular because of the pandemic.

Supply chains are another area that will shape ESG considerations in the years to come. The pandemic has highlighted the interdependency of several sectors and countries to the operational viability of just-in-time supply chains. Moving forward, global companies are now considering redesigning their global footprints, taking into consideration the risks that arise from globally distributed supply chains, and seeking to minimise these threats by incorporating ESG criteria.

Geopolitics, economic developments and political events are other indicators that can influence a business or investor’s approach towards ESG. Inequality, distribution of wealth and demographic shifts are also playing an important role in ESG embracement.

Although ESG is seen as a crucial part of the decision-making process by many, there are still organisations overlooking ESG criteria, often in an attempt to benefit from lower operating costs. However, the pandemic has highlighted that such practices carry great risk over the long term, especially at a time where there is great financial uncertainty in many countries around the world. ESG is something that cannot be ignored by any investor, and its importance is only going to grow as the world emerges from the Covid-19 pandemic.