Emerging Trends in Sustainable Investing
Sustainable investment is an approach to investing whose focus is to incorporate Environmental, Social and Governance (ESG) factors into decision making by managing risk adjusted returns and the generation of financial performance. It is widely recognised that the integration of ESG in the investment process is considered an emerging field which has become mainstream.
Sustainable growth has become a focus for investment companies and has rapidly risen up the agenda of regulators, policy makers, and investors alike. Europe has led the way and member states have adjusted their regulatory outlook in including sustainability factors in the financial sector. A significant driver of the European Commission (EC) support for the integration of ESG criteria in the financial markets is based on the European Union’s targets as set down in the Paris Climate Agreement to achieve 2030 targets. These cover a 40% cut in greenhouse gas emissions and there is an investment gap to fill estimated at €180bn EUR per annum as cited by the EC of which capital markets will play an important part.
The appetite for responsible investing is influenced by demographic shifts, climate change, and technological advancement which have led to investors and in particular millennials seeking out transparency in investment processes and demanding sustainable investment products. The new generation of more financially literate investors recognise the financial effect of their values and are making informed decisions on their portfolio selection without having to compromise performance. By using ESG information in their financial analysis investors are able to evaluate which companies to select or avoid based on long term financial risk and rebalance their portfolios accordingly.
ESG terminology and EU regulation
Sustainable investing can mean different things to different investors and indeed to investment professionals. The lack of consensus in ESG terminology raises difficulties for investors to compare products and providers which can lead to uncertainty and have a knock-on effect on the attractiveness of ESG products. The Council of the EU in September 2019 has agreed a proposed regulation - the ‘Sustainable Investment Regulation’ - to create a framework to facilitate responsible investment. This will include the development of a common taxonomy and the harmonisation of disclosure requirements across EU member states to promote ESG and to make it appealing for the deployment of capital. The classification scheme is expected to be established at the end of 2021 and be applicable by the end of 2022. The intention is to reduce “greenwashing” and provide comprehensive guidelines on how firms integrate ESG within their investment infrastructure.
ESG and the improvement of risk adjusted long-term financial returns
There is growing recognition in the industry of the link in incorporating ESG issues into portfolio management and the improvement of risk adjusted long term financial returns. The longer term time horizon is necessary for returns to be realised which institutional investors and pension funds are familiar with. Investment decisions carried out through the lens of ESG factors covering asset class, sector, and geographical location are impacted by ESG related risks. Each level of the value chain of the investment is evaluated and risks are adjusted depending on the impact on financial performance. ESG criteria cover issues that would not traditionally be covered by financial analysis and yet have financial implications. Such considerations include corporate culture and climate change. The ESG prism can expose what new and emerging risks a mandate has exposure to in addition to assisting with assigning values to intangible parts of an asset valuation. This holistic approach of ESG integration into investment processes and decision-making covers a wide range of factors and is not solely the screening and avoidance of potential investment types such as tobacco, alcohol, and firearms.
The integration of sustainability into the investment framework encompasses investment and risk management processes, governance, technological and team resources. The emergence of the availability of data sources with improved data has made it easier and cost effective to integrate ESG criteria into investment processes. Better methodologies allow for better interpretation of the data which further supports investment selection and monitoring. Challenges do remain with gaps and data can be imperfect but reporting is getting better and easier to access which has financial implications on the risk analysis of all asset classes.
Ireland and ESG
Ireland is committed to its positioning as a green finance centre complementing its world class financial services centre of excellence. The Ireland for Finance Strategy for the development of Ireland’s International Financial Services sector (IFS) to 2025 comprises sustainable finance as one of its priorities citing 81% of asset managers have in place a responsible investing policy. As part of Ireland’s green commitment, the country was one of the first European movers to issue a green bond raising €3bn. Furthermore in 2018 Ireland was the first country to sell off its investments in fossil fuel companies.
The momentum in sustainable investing continues to gain traction. The main aspects of investor demand, social and demographic changes, new business initiatives, and increased governmental and regulatory attention remain at the forefront. We anticipate the revision of the Investment Limited Partnership (ILP) to benefit Ireland as a location of choice for establishing private equity, and infrastructure funds as the preferred fund type for real assets. Investors are aligning their responsible investing goals with long-term financial risk adjusted performance. Investment firms are increasingly aware of ESG factors and this in turn is influencing their investment offerings and product strategies. The mounting evidence shows that portfolio allocation can be impactful without eliminating diversification or financial returns with ESG risk and reward profiles factored in to balance long term sustainable portfolios. A key ingredient in product development will be the cost of incorporating sustainability in the investment model to remain competitive and attractive to investors.
Vanora Madigan, Director - Relationship, DMS