Environmental, social, and governance investment concerns

Social Governance

According to the current challenges world is facing these days and debates going on around the globe world, it is highly predicted that, the size of ESG investment is likely to increase on a large scale in coming future. Based on the following, there are some ESG investment concerns need to be addressed:

Major ESG Compliances

Usage and definitions of various terminologies linked with ESG or socially responsible investing (SRI) are ambiguous, vague and need more clarity for the investors. Furthermore, ESG encompasses a wide range of conflicting issues and areas. How should an investor evaluate the importance of carbon emissions versus racial and gender discrimination. For example, some of the ESG compliant investment portfolios comprise of large number of tech companies indicate a positive score on environmental issues, but these same tech companies don’t have good historical records in hiring and promoting women and minorities. This shows open contradiction towards the achievement of ESG objectives and going into right direction.

Establish an ESG portfolio

One of the best solution and way forward in this regard for investors is to use specialized tools of financial service providers to establish an ESG portfolio which matches their specific interests and requirements. The financial services and specialized tools of firms are available but there is huge information and transaction costs associated. Achieving consensus on ESG issues, related to investment portfolios, will continue to be more challenging according to the changing and complex scenarios. It is established fact that the Governance issues are easier to gain agreement in comparison of some of the most complex environmental and social issues and it is interesting to note that several empirical studies found that positive Governance scores were linked directly with financial performance and growth.

Investors, today, are more interested in understanding the ESG features of their investments.

Data Management

Issues related to data must be answered. As we expect improvements in ESG, it demands considerable time and efforts to manage data effectively. Some of the companies disclose data related to ESG, and some companies avoid to make it public. It is also observed that some firms disclose inconsistent ESG data. Most of the data figures disclosed are usually self-reported by companies, with often questionable consistency in the current times. Some other data issues are as follows: Materiality – the factors being measured or reported important or fundamental to the company’s efforts. Coverage -less than 5% of the world’s publicly listed companies report their emissions. Outcomes versus inputs -where measures of outcomes are not available, such as actual quantity of emissions, alternatively inputs such as budgets or staffing which can be identified as addressing emissions. But the efficacy of inputs can be highly variable: a company devoting substantial inputs to pollution concerns may yet have higher emissions than a company with half that level of inputs.

There is no universal definition for the various forms of investment which will lead to positive social or environmental outcome in addition to earning reasonable financial return.

The future of environmental, social, and governance Investing

Some common conclusions about the future of ESG investing:

Investors, today, are more interested in understanding the ESG features of their investments. Therefore, the number of companies providing corporate responsibility reports will increase significantly and the quality of that reporting will improve as well compared to current reporting in this area. Companies will deploy more corporate resources on ESG issues at the expense of financial returns in short term to investors. Core purpose of this significant deployment of the financial resources will be motivated by the strategic objective for the company to be a responsible corporate entity, brand imaging and result of personal interests of those charged with governance. Institutional investors will increase their extent of engagement with the investee companies. Financial service providers will continue in the field of innovation and research related to new ESG products. The quality of ESG will improve.

Empirical studies of environmental, social, and governance investment performance

There are many historical studies in this area indicating conflicting results, several studies support the fact that companies with strong ESG performance also score at a high level on traditional financial indicators.

Results in a summarized form of the studies indicates that as follows:
90% of the studies show that sound sustainability standards lower the cost of capital;88% of reviewed sources find that companies with comprehensive sustainability practices leads to better operational performance, which ultimately converted into cash flows; and 80% of the reviewed studies support the conclusion that companies with strong ESG performance also score positively on traditional financial indicators.

100% of the academic studies demonstrates that companies with high ESG ratings have a lower cost of capital in terms of debt and equity and 89% of the studies shows that companies with high ESG ratings indicated market-based outperformance, while 85% of the studies show these companies indicated accounting-based outperformance.

It is interesting to note that several empirical studies found that positive Governance scores were linked directly with financial performance and growth.

ESG, SRI, and impact investing

There is no universal definition for the various forms of investment which will lead to positive social or environmental outcome in addition to earning reasonable financial return. The term “environmental, social, and governance (ESG) investing” is attributed to a 2004 report (The Global Compact, 2004) which reported the conviction of more than 20 of the world’s largest financial institutions that positively addressing ESG issues is important to the overall quality of companies’ management. They further stated that: “Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value. ESG is sometimes used as a catchall label to describe any investing style which has an element of social purpose. Investors or fund manager invests in public debt and/or equity, often via mutual funds or exchange-traded funds. The portfolio often has an objective of earning a market rate of return, while investing in assets which score favorably on ESG factors.

Socially responsible investment

Socially responsible investment (SRI) focuses on the impact of companies in specific areas of interest. It most commonly involves investing using a negative screen which would exclude companies engaging in activities the investor finds undesirable. For example, an SRI investment strategy could exclude companies involved in alcohol, tobacco, gambling, and/or guns. Countries with patterns of human rights abuses have also been screened out of portfolios.

This investment style doesn’t always have to be focused on exclusion of bad actors. It may instead proactively invest in companies which feature activity in social justice, or environmental solutions. It may also include investment in organizations providing services to a local community. But the most common distinction is that SRI factors result in screening out certain companies while, in contrast ESG investing gives guidance on what companies to include within an overall portfolio approach. A major concern is that a strategy of simply excluding companies may lead to portfolio returns that underperform market benchmarks. Older studies showing the historical underperformance of these funds are often cited as evidence of the poor performance of all SRI and ESG funds, whether divestment oriented or more sophisticated.

Finally, we can say ESG investing at its core seeks to contribute assets to companies pursuing ESG goals, or to influence companies to do so. But some questions to what degree companies should pursue nonfinancial goals. One of the most important writings on the purpose of a firm is Milton Friedman’s “The social responsibility of business is to increase its profits” (Friedman, 1970). The majority of corporate executives, boards, and investment managers still agree with Friedman’s view but after 50 years, many others think that this is not the whole answer.

Green Accounting

This article was first published by Chartered Accountants Ireland at the following URL: https://icap.org.pk/files/per/publications/PA/2022/apr-june/apr-june-2022.pdf