Once a niche area, ESG has become a mainstream topic in financial services. The acronym stands for Environmental, Social and Governance: the environmental element refers to how a company performs as a steward of nature; the social element examines how a company manages relationships with employees, suppliers, customers and the communities in which it operates. While ‘governance’ relates to a company’s oversight and internal control in delivering these objectives. Together, they refer to an approach which considers broader issues of ‘public interest’ alongside businesses objectives of delivering a financial return.
So called, sustainable finance is not a new phenomenon. Some trace its origins back over 200 years to religious groups that based their investments on ethical and religious values. But the recent growing popularity of investment strategies incorporating ESG criteria is one of investment sector's biggest trends. The reasons for this drive are varied.
Societal and investor attitudes
Investor attitudes have been one driver in the move towards more sustainable finance. More investors want their money to be invested in a sustainable way or in a way that makes a positive impact. Companies face greater scrutiny in relation to their investments and are expected to be more accountable in respect of the investments they make.
Commentators note that an increasing number of young investors in particular are likely to prioritise ESG investments. These issues are increasingly highlighted in adverts designed to attract savers into the investment market.
Political pressure
The United Nations has committed to fulfil 17 Sustainable Development Goals aimed at eliminating extreme poverty, reducing inequality, and protecting the planet. The Paris Agreement, signed by 174 states and the European Union, specifically addresses climate change. These initiatives have placed climate change and sustainable development high on the political agenda.
The EU has been at the forefront of the drive to ensure greater consideration is given to ESG issues in investment decisions. Climate change and sustainable development have now been mainstreamed into EU policies and legislation.
Regulatory change
What were once voluntary considerations will shortly become mandatory requirements. This includes the development of rules requiring institutional investors to be transparent about their approach to ESG. Companies will also need to make additional disclosure in relation to ESG claims made about an investment product. Advisers will have to ask clients about any ESG preferences they may have.
This is just a small sample of current ESG initiatives. Reports suggest that, since 2013, there has been a 72 percent increase in the number of regulations concerning ESG issues.
Closer to home the FCA is developing its own policy and has emphasised the importance of ESG to market stability and resilience by linking ESG to its statutory objective of market integrity. It has even suggested that ESG has a role to play in preventing consumer harm for those who may have insufficient retirement income.
Whether demand for investments designed to deliver environmental or social outcomes will move from a minority to the mainstream remains uncertain. Certainly, the track record of new launches in this area is mixed.
Nonetheless, broader political and regulatory developments make it certain that levels of these types of funds will increase. From 2020, for example, pensions funds will have to explain their ESG approach which may have a significant effect on the market.
What is certain is that investment companies, and their managers, will have to consider what, if any, practical responses they may have to make to this growing and increasingly high-profile trend.