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1. Looking beyond Carbon Emission — Expanding the Scope of ESG
In the past few years we have been trying our upmost to align ourselves with the Paris agreement and extensively focusing on climate change and reducing carbon emission. Nevertheless, we have to be aware of the fact that ESG stands for “Environmental, Social and Governance”. It is a comprehensive framework and is much more than this single slogan of “Going Green” by reducing carbon footprint.
On the environmental side, biodiversity, water pollution, are all gaining more attention, from academic researchers, from the government and most importantly, from investors. The economic cost of lost in biodiversity is much greater than we previously thought of. According to the IPBES (Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services), $44 trillion of economic value generation is highly dependent on our precious Mother Nature. Just to give you an idea of the degree of impact, $44 billion is over half of the world’s total GDP. Businesses that neglected the importance of Biodiversity have come to greater awareness of the ‘hidden dependence’ of their supply chains on nature. Industries such as Construction, Agriculture, Food and beverage, which combined, have a value of twice the size of German economy, are the top three industries that are heavily damaged by loss in biodiversity, the economic cost of loss in habitat and disruption of the ecosystem is huge.
“Given the scale and severity of nature loss, business needs a wake-up call, The cascading physical, regulatory and legal, market and reputation risks we see mean nature risk now needs to be a mainstream issue for corporate enterprise risk management. — Celine Herweijer, Partner and Global Innovation and Sustainability Leader, PwC UK
But still, we have to consider the ‘Social’ component of ESG. ‘Social’ stands at the middle of ‘Environmental’ and ‘Governance’, it is what really puts everything together. Without an efficient and stable social system, implementation of incentivizing policies, the monitoring, and the evaluation of ESG objectives will be extremely difficult. In 2020, COVID-19 crisis has imposed a significant challenge to social inequalities: the closing down of schools, small businesses unable to withstand demand crunches, racial inequality crisis in the US. In order to maintain a stable social system, more attention needs to be given to the Social aspect of ESG. Investors play a key role in exploring innovative solutions to reduce social inequalities. In 2021 we are likely to see more contributions from both the business side and the investor’s side to invest in financial product that incorporate this aspect, such as social bonds, where the proceeds from the bond will be used to fund projects that promote social equality, supporting the vulnerable.
The percentage of social bond is projected to grow to 15%, although the regulatory and assessment of these bonds are not as well established as green bonds, the shift of investor’s focus will eventually draw more attention to this field and urge regulatory institutions to enforce more rules and monitoring measures, actively promoting investments into social bonds.
2. Booming Phase of ESG Investment
In the early phase of the development of ESG investing, the question that was being asked most frequently by investors is ‘Do ESG investments really outperform?’. Indeed, the ultimate drive behind investing is to generate return, and in the past few years, ESG focused financial products have proven itself to be able to meet investors’ expectations. According to MSCI ESG Research: for the past 5 years, U.S. companies with high ESG rankings in the S&P 500 index have outperformed their counterparts with lower ESG rankings by at least 3% every year. The consistency of outperformance has driven more investors to be willing to consider adding ESG investment products into their portfolio. Demand is rising dramatically, just looking at the US market, flows into sustainable funds reached US$8.9 billion through the first six months of 2019, compared to US$5.5 billion in all of 2018.
With surging demand, there has been increasing pressure from investors to urge their asset managers to adopt ESG investment elements when constructing portfolios. According to Russell Investments’ sixth-annual ESG Manager Survey, 78% of 400 asset managers across a variety of asset classes and geographical regions now explicitly incorporate qualitative and quantitative ESG factor assessments into the investment process. There is also effort from regulatory authorities to push for positive changes. In March 2021, EU Sustainable Finance Disclosure Regulation will require asset managers to report on the sustainability characteristics of their investments. This will be a driving force for the widening and deepening of the scope of ESG investing, and the growth of ESG investments in 2021 is definitely very optimistic.
“ESG is no longer an optional ‘add-on’; it is now an essential consideration that asset managers have to incorporate into their decision-making processes. — Jihan Diolosa, Head of Responsible Investing EMEA
We’ve seen this trend in individuals and asset managers, but more importantly, many large banks are also taking the lead to set the stage for ESG investments. More banks are tying up their compensation to asset management with their ability to meet ESG criteria. For instance, for BNP Paribas it’s arond 20% of its variable pay , and on December 7th, 2020, Deutsche Bank also disclosed its plan to associate asset management compensation with hitting sustainable finance investment goals in 2021.
More participants in our economy is joining the move to align their goals with ESG objectives, Paris agreement and sustainable financing. As more funds are be devoted to investments in this space, this provides greater liquidity, more optimistic market conditions, and will eventually drive for greater return and lead us to a positive feedback loop.
Another factor that contributes to this rapid growth phase is the fact that the categories and asset types of ESG investment have expanded and will continue to expand in 2021. Except for ESG bonds, ESG ETFs and ESG stocks that we are familiar with, many alternative investments have also decided to incorporate ESG components. An active player is ESG hedge fund, more hedge funds are adopting ESG principles as asset owners seek to integrate ESG considerations across their entire investment portfolio. ESG investing is also increasingly recognized by hedge fund as a means to improve risk return profile. Primarily adopted by multi-strat hedge funds and equity long/short strategies, ESG hedge fund is growing rapidly and it is very likely to see competition driven adoption of ESG hedge fund into other strategies. ESG in real estate is also growing substantially, ‘Green real estate’ and ‘Green building’ have been gathering momentum and attracting more investors. According to the World Economic Forum, back in 2016 there were already 40–48% of new commercial built as “green”, compared to only 2% in 2005, and they have projected that it would rise to 55% in 2020. Other asset classes with ESG policies in place include private equity, venture capital, infrastructure and commodities market. A combination of these growth factors are evidently signaling to us that ESG investing will definitely experience its boom phase in 2021.
3. Data and Technology — Bridging the Data Gap
One of the biggest concern regarding ESG investing is the standardization and completeness in reporting ESG data. How can we be more confident that a company is indeed doing good to the environment instead of just ‘Green Washing’ itself to fool ESG driven investors? How do we measure the environmental impact of firms and how they have improved? What can be truly considered as ESG investments? These are all questions that can be answered by feeding in data that are accurate, highly relevant, consistent and transparent to efficient data analysis tools. Technologies will helps us to make more informed decisions, we have discovered more innovative methods to automate and improve data collection and analysis in ESG’s playing field.
Artificial intelligence have provided many possible solutions to bridge the existing ESG data gap. One key technology that can be a solution is Decentralized Ledger Technology (DLT). DLT is most well known for blockchain and how it is the fundamental structure supporting cryptocurrencies like bitcoin. However, in its essence, DLT is an immutable, real-time verifiable shared database of tokenized assets. This might sounds confusing, but what this means is that data can be recorded and tracked without worrying about someone secretly trying to change it. Once the ‘block’ is appended to the chain, it is verified and unchangeable ( unless there is a 51% attack, which is very unlikely). This piece of technology ensured the accuracy and reliability of ESG data.
But what about collection of data? One possible answer is the Internet of Things ( IOT). IOT provides us with an efficient and automated approach to collection of ESG data. The fact that it is a mature technology that has been around for many years improves its accessibilities to businesses and investors. The recipient of the Green Supply Chain 2017 Award — cargo tracking and monitoring service Arviem was awarded for its use of IoT-enabled real-time carbon footprint monitoring technology. Back then, the use of IoT in ESG data collection was groundbreaking, but now, more IoT solution providers are shifting towards provision of ESG data collection services. Their capabilities, the type of data they could collect have greatly expanded. For example, Microshare’s IoT data solutions include collection of data related to energy efficiency, water usage, supply chain management and even workforce health and safety. Greater democratization of IoT data collection solutions will be a crucial factor for ESG development in the years to come.
Moreover, the question ‘Does ESG investments outperform’ can also be better answered by the use of artificial intelligence. TruValue Labs uses AI to monitor more than a million data points based on the SASB framework to track ESG-related performance over time. This AI based performance evaluation approach allows investment managers to better track and test the effect of incorporating ESG investments on their portfolios, which not only helps to enhance future performance, but also gives investors and portfolio managers more confidence in the potential of ESG investing.
In the upcoming year of 2021, technology advancement, coupled with more regulation and rules to be established in terms of standardization of ESG data reporting will make investor’s trust a key area of focus as we thrive to find better solutions.
References:
“Can ESG Investing Provide Better Stock Returns?” Bank of America Merrill Lynch, www.bofaml.com/en-us/content/esg-investing-research-report.html.
“Environmental Sustainability Principles for the Real Estate Industry.” World Economic Forum, www.weforum.org/whitepapers/environmental-sustainability-principles-for-the-real-estate-industry.
“ESG No Longer an Optional ‘Add-on’ for Asset Managers, Finds Russell Investments Study.” Institutional Asset Manager, 6 Oct. 2020, www.institutionalassetmanager.co.uk/2020/10/06/290515/esg-no-longer-optional-add-asset-managers-finds-russell-investments-study.
“Global Assessment Report on Biodiversity and Ecosystem Services.” IPBES, ipbes.net/global-assessment.
Hackenberg, Jonquil. “Redefining ‘Normal’: The Top 5 ESG Trends For 2021.” Forbes, Forbes Magazine, 10 Dec. 2020, www.forbes.com/sites/jonquilhackenberg/2020/12/10/redefining-normal-the-top-5-esg-trends-for-2021/?sh=14cf05d314e2.
Papadopoulos, Kosmas, and Rodolfo Araujo. “Top 10 ESG Trends for the New Decade.” The Harvard Law School Forum on Corporate Governance, 2 Mar. 2020, corpgov.law.harvard.edu/2020/03/02/top-10-esg-trends-for-the-new-decade/.
Reuters, Thomson. “Deutsche Bank to Link Management Pay to Sustainability Targets.” KFGO, 7 Dec. 2020, kfgo.com/2020/12/07/deutsche-bank-to-link-management-pay-to-sustainability-targets/.
“Russell Investments’ Sixth-Annual ESG Survey: ‘Governance’ Remains the Dominant Consideration for Asset Managers as They Increasingly Amplify ‘Environment’ and ‘Social Factors.” Russell Investments’ Sixth-Annual ESG Survey | Russell Investments, russellinvestments.com/us/about-us/newsroom/2020/russell-investments-sixth-annual-esg-survey-governance-remains-the-dominant-consideration-for-asset.
“Social Inequalities Test Investors’ Creativity.” MSCI, www.msci.com/our-solutions/esg-investing/2021-esg-trends-to-watch/social-inequalities-test-investors-creativity.
“Trending: Harnessing Big Data, IoT for Enhanced Supply Chain, ESG Performance.” Sustainable Brands, 6 Dec. 2017, sustainablebrands.com/read/product-service-design-innovation/trending-harnessing-big-data-iot-for-enhanced-supply-chain-esg-performance.