BlogESG investing: what do businesses and investors need to know?

ESG investing: what do businesses and investors need to know?

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As world leaders meet for the COP26 in Glasgow against a backdrop of a pandemic far from over and increasing demand for action to tackle climate change, we can expect a renewed focus on ESG investments.

ESG investing is on the rise and fast becoming mainstream. According to the Global Sustainable Investment Alliance’s 2020 review: “At the start of 2020, global sustainable investment reached USD35.3 trillion in the five major markets covered in this report, a 15% increase in the past two years (2018-2020) and 55% increase in the past four years (2016-2020).”

Previously considered niche, risky or low return, now ESG investment strategies are a huge growth area, fuelled by increased market demand and regulatory requirements.

In an interview with MIT Management Sloan School in September 2021, George Mussalli, chief investment officer and head of research at PanAgora Asset Management, said: “We believe sustainable investing is one of the biggest market disruptions and opportunities, which is revolutionizing investing today”.

What is ESG?

ESG stands for Environmental, Social and Governance, and refers to a set of criteria for sustainable corporate practices and investments.

The term was introduced in 2004, although the idea of sustainable investment has been around for much longer.

In early 2004, then United Nations Secretary-General Kofi Annan invited a group of leading financial institutions from around the world to develop a set of guidelines for investors on how to incorporate environmental, social and governance considerations in investment decisions. The result was the Who Cares Wins report and the establishment of the Principles for Responsible Investment (PRI), which were launched in April 2006.

Around 4,000 investment managers, together responsible for over $120 trillion in assets, have signed up to the UN-supported PRI since its inception, with each of them committing to adopt and implement six principles (where consistent with their fiduciary responsibility to act in the best interests of their beneficiaries):

Principle 1:

We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2:

We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3:

We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4:

We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5:

We will work together to enhance our effectiveness in implementing the Principles.

Principle 6:

We will each report on our activities and progress towards implementing the Principles.

Why is ESG important?

ESG is becoming impossible to ignore, as younger generations of consumers and investors place more pressure on governments, companies and the financial sector to adopt sustainable practices.

“Covid with climate change disasters, UN IPCC assessment report and the upcoming COP26 Climate Conference provide constant ‘top-of-mind’ investor interest,” says Andrew Busch, the former 1st Chief Market Intelligence Officer for the US government.

Demand is surging for action in the face of the effects of climate change and the impact of the pandemic on society and the economy. Risk-averse companies and funds will consider the consequences of not adopting ESG criteria in their practices and investments, and the likelihood of increasing regulation. Increasingly, too, companies and investors are keen to make the most of growth opportunities.

Either way, ESG is a fundamental part of the international community’s efforts to meet sustainability goals aimed at, among other things, tackling climate change and increasing equality.

What do businesses and investors need to know about ESG?

Businesses and investors should prepare to respond to growing investor demand and increased regulatory requirements for them to act and invest sustainably.

They will need to know how to meet ESG criteria. In addition, governments and regulatory bodies around the world are developing regulations and policies around sustainable investment, such as the award of approved status and requiring disclosure to prevent ‘greenwashing’ and promote transparency and accountability.

With the increased attention on sustainability and world leader summits such as the COP26 (31 October-12 November 2021), an increase in policy making in different regions over coming years is highly likely.

What is ESG investing?

ESG investing refers to the practice of considering environmental, social and governance factors when making investments. An ESG investment would be one in a company or fund committed to sustainable practices in these areas – for example, this could be by minimising its impact on the environment, contributing to society, or maintaining transparent accounting and reporting methods.

More and more investors are interested in evaluating ESG factors, and increasingly, companies and funds are becoming more transparent about how they integrate ESG in their practices and investments.

ESG criteria is broad and can range from a company’s impact on human rights to its adoption of low-carbon production techniques, or from its contribution to its local community to its lobbying practices. Often, the challenge is finding clarity and consistency in the criteria, especially across different regions.

For example, the UK regulatory public body the FCA wrote to investment managers in July 2021 with detailed guiding principles to complement the existing legal regulations in response to applications for ESG status falling below expectations.

For those companies and funds that are successful in establishing their commitment to ESG issues, there are significant opportunities to capitalise on increased investor demand.

What are the ESG requirements for funds in Europe?

In its 2020 review, the Global Sustainable Investment Alliance sets out current and proposed regulatory requirements in Europe:

Sustainable Finance Disclosure Regulation (SFDR)

Under SFDR, institutional investors, asset managers and advisers must report on sustainability risks and adverse impacts, both of their business and of their investments.

Corporate Sustainability Reporting Directive (CSRD)

A proposal adopted by the European Commission in April 2021, extending the reporting requirements of the existing Non-Financial Reporting Directive (NFRD), the CSRD requires all large listed companies to report on their ESG impact.

Markets in Financial Instruments Directive 2 (MiFID II)

The suitability rules under the EU’s proposed MiFID II directive mean funds, asset managers and advisers must take into account investors’ ESG preferences when offering investment advice or portfolio management services.

EU Taxonomy Regulation

Adopted in 2020, the EU Taxonomy Regulation defines four criteria investments must satisfy to be classified as environmentally sustainable. Further taxonomies are planned related to the other ESG criteria.

The EC’s new sustainable finance strategy

Adopted in July 2021, the new strategy “aims to support the financing of the transition to a sustainable economy by proposing action in four areas: transition finance, inclusiveness, resilience and contribution of the financial system and global ambition.”

In addition to these policies and regulations, Europe-based funds should be mindful of industry-led initiatives:

Voluntary sustainable fund labels

Across many European countries, funds can use labels to signal their adoption of ESG criteria. These labels exist in France, Belgium, Luxembourg and Austria. There are also cross-border labels for Switzerland, Germany and Austria, as well as for the Nordic region.

Financial Data Exchange Templates (FinDatEx)

The European financial services sector is coming together to develop a standard ‘European ESG Template (EET)’ to simplify compliance with regulations such as the SFDR and the MiFID II.

Net Zero Asset Owner Alliance (NZAOA)

Convened by the UN, NZAOA is an alliance of 42 institutional investors, (32 of which are based in Europe) which have committed to adjusting their investments to help meet the 1.5C target set out in the Paris agreement of December 2015.