Around the world, sustainability is playing a greater role in financial services. In Australia, superannuation funds and other institutional investors are leading the way by increasingly incorporating environmental, social and governance (ESG) factors into their portfolios. As a result, investment managers in Australia and around the world must consider how ESG factors may impact the risk and return of their investments, while also facing added pressure to provide transparency into their ESG practices.
Among the drivers that have brought sustainability into the spotlight are demographic trends as the world’s population continues its rapid growth, scarcity of natural resources and climate change — all catalysts that are altering how business is conducted globally. Furthermore, in the wake of the global financial crisis, the need for good corporate governance — a fundamental component of reputation and risk management — has never been greater.
Investors in Australia and New Zealand are keenly aware of these trends. That awareness is prompting investors to instruct their advisors to integrate climate change in their advice more frequently, according to a recent Mercer report.1 The report details how almost half of Australian investors include a climate change statement in their investment management agreements, while 69 percent of investors are considering an allocation to climate change-related investments within the next three years. Australia’s forthcoming carbon tax will likely further these trends by heightening awareness of ESG investing.
ESG’s Increasing Traction
One of the appeals of corporate sustainability is that it is a long-term value creation strategy. When incorporated into a firm’s investment decisions, it should yield superior performance, provided the company is well governed and operates in an environmentally friendly and socially responsible manner.
The United Nations Principles for Responsible Investment (UN PRI) have been providing a framework for investors to voluntarily incorporate ESG factors into their investment processes since they were enacted in 2006. The UN PRI counts the Australian Council of Superannuation Investors among their more than 800 organizational endorsers, representing 45 countries and over AU$18 trillion in assets. Moreover, asset owners and managers representing more than half of all Australian assets under management are now UN PRI signatories.
In 2010, there was a 29 percent increase in Australian signatories to the UN PRI, notes the Responsible Investment Association Australasia’s most recent annual research report. The report also indicates that managed responsible investment portfolios rose 10 percent from AU$14.02 billion to AU$15.41 billion.
Furthermore, according to ESG Research Australia, ESG research has become more rigorous in the past 12 months and more analysts are including ESG issues in their reporting. These trends have prompted investment managers to meet client needs with enhanced product and service offerings. State Street, for example, has developed a suite of ESG services for pension fund managers and institutional clients to help them assess ESG risks in their portfolios, implement a responsible investment strategy and fulfil UN PRI reporting requirements.
Evidence Helps Make the Case
Despite its momentum, more facts are needed before ESG can move further into the mainstream as a viable investment strategy. A 2008 study by State Street Global Advisors (SSgA) suggested that, although ESG ratings had variable predictive power overall, there is a forecasting ability in pockets of the universe.2 In addition, in some instances predictive power actually tended to strengthen over time. This predictability implies that ESG-related matters have gradually become part of the investment landscape and that, in the future, they may increasingly become a source of alpha for investment purposes.
It is important to note that a limitation of this study, and of most others that originated before 2008, is that it does not include any significant bear market periods. However, new research that examines ESG in bear markets outlines a number of supporting observations on the dimensions of return and risk. The research, also conducted by SSgA, shows that high-scoring ESG corporations generally suffered less during down markets, and that there is evidence of fat-tailed risk protection.
Taking a New Approach
The disconnect that many see between the short-term time horizons of traditional financial analysis and the long-term nature of the business impacts of ESG investing, is one of the challenges to overcome on the road toward a more sustainable economy. It is critical for super funds and investment managers alike to rethink their traditional investing models and to identify potential new sources of return and/or protection against risk — a point made even more salient by the passing of the carbon tax.
The evidence suggests that the financial implications of sustainability issues are likely to grow significantly going forward. By working to align themselves with this movement now, super funds and investment managers may be better positioned for the future.
1 Mercer, “The Climate Change Report: The Impact of Climate Change on Strategic Asset Allocation,” June 2011.
2 SSgA“A Comprehensive Analysis of the Relationship between ESG and Investment Returns,” 2008.
Super Review, September 2011
