ESG Investing: A (Re)Introduction to Responsible Investing

Meredith Jones is a Partner in Aon Hewitt’s Global Investment Management group and is based in Nashville, TN.


In recent years, and particularly in the last 12 months in the U.S. (thanks to more Responsible Investing-friendly regulatory stances), investors have become increasingly interested in “doing good while doing well” when investing. Unfortunately, this relatively nascent area of investing still has more than its share of linguistic anarchy and execution challenges, which can be trying for even the most committed individual or institutional investor. Many investors and industry participants even struggle with basic nomenclature to describe their efforts and what they may ultimately want in an end investment. Is it Sustainable Investing? Or maybe Socially Responsible Investing? Or perhaps ESG Investing? Mission Investing? Impact Investing? And when one person says tomato, does another hear tomahto? Given the vast umbrella of potential strategies, the chance of misunderstanding an investor’s intent is fairly high.

In order to restore some cosmos to the linguistic chaos, Aon has broken the universe of potential Responsible Investments down into four main components: Socially Responsible Investing, Environmental, Social and Governance (“ESG”) Investing, Impact Investing and Mission-Related Investing.

Socially Responsible Investing (“SRI”) tends to be the area with which most investors are familiar, as it is the oldest of the four broad Responsible Investment categories. SRI uses a negative selection process to exclude certain sectors or investments from a portfolio. ESG (Environmental, Social & Governance) Investing, Impact Investing and Mission Related Investing are newer to investor’s toolkits and typically focus more on positive investment inclusion criteria rather than on negative screening.

In addition to utilizing different screening techniques, the drivers of investment may be different as well.  Socially Responsible Investing (SRI), Mission Related Investing and Impact Investing are generally dependent on an individual’s or institution’s values to determine suitable investment options. In SRI, for example, investors generally seek to avoid certain investments they feel are not acceptable based on a value system set either by the individual or by the organization. Similarly, in Impact Investing, an individual or an organization may make a value judgment about how they want to positively impact a particular group or investing sector, while still generating an investment return. Many of those that engage in Impact Investing use this strategy to leverage their philanthropic efforts, and as a result, Impact Investing can be a preferred tool for foundations and other charitable organizations. Mission Related Investing supports the mission or missions of a particular group and generally also seeks to avoid investments that run counter to the mission. A group focused on child welfare might choose to invest firms providing healthy school lunches, for example, but not in companies that employ child labor in order to maximize adherence to their stated mission.

ESG Investing, however, is fundamentally different from its Responsible Investment peers. Instead of being driven by personal or organizational values, investment decisions are directed by the fundamentals of the company. Non-financial ESG factors are considered to the extent they are material to the company’s future financial performance. ESG factors that may be considered material to a company’s financial performance could include the following:

  • Environmental factors – use of water, alternative energy, and climate change, etc.
  • Social issues – diversity, working conditions, consumer protection, human rights, etc.
  • Corporate Governance – transparency, disclosures, reporting, incentives, board composition, executive compensation, checks and balances against fraudulent activities, etc.

These non-financial factors are generally believed to potentially impact both an investment’s sustainability and profitability. For example, a 2012 Deutsche Bank study “Sustainable Investing: Establishing Long Term Value & Performance”, eight studies linked strong corporate governance to financial outperformance, while five studies linked environmental factors to outperformance. Although only one study linked non-financial social factors to outperformance, there is a growing body of research that suggests issues like diversity do have a material impact on financial performance. For example, a study done by Catalyst showed that businesses with the most females had, on average, 42% greater return on sales and 66% greater return on invested capital1

Regardless of where an investor or organization falls on the Responsible Investing spectrum, we expect the trend towards “doing good while doing well” to continue to grow in the future, partly due to shifts in demographics and the generational wealth transfer, as well as to changes in regulations and investor-led initiatives. 

Demographic Changes – Younger generations (Millennials and Generation X) are more likely to consider an investment’s social or environmental impact than older generations1. These groups now comprise the largest share of the workforce and stand to inherit additional wealth from Baby Boomer and Senior generations.

Regulatory Changes – In 2015, both the US Department of Labor (“DOL”)2 and the Internal Revenue Service (“IRS”)3 opened the door for additional non-profit allocations to Responsible Investments, stating that such investments did not compromise fiduciary duty (DOL) or non-profit tax status (IRS).

Investor Led Initiatives – Mega investor CalPERS announced in May 2015 that all external fund managers must “identify and articulate ESG in their investment practices4. In addition, asset owner, investment management and other signatories to the United Nations Principles for Responsible Investment (UNPRI) grew by 9.5% between April 2014 and April 2015. Assets under management subject to UNPRI guidelines grew by 31.1% during the same period5.

Anecdotally, Aon Hewitt is seeing an increase in the number of investors looking for additional education about ESG, Impact and Mission Related Investing. In addition, many are looking to implement a plan that addresses their Responsible Investing concerns. Clearly, given variations in individual and organizational values, regulations, investment policy statements, internal and external pressures and conflicting performance data, there is no one-size-fits-all solution. However, we anticipate that this will continue to be an area of both focus and rapid evolution.
 

[1] http://www.institutionalinvestor.com/article/3517495/investors-registered-investment-advisers/how-millennials-shape-socially-responsible-investing.html#.WBPFRkZyVKk

[2] https://www.dol.gov/opa/media/press/ebsa/ebsa20152045.htm

[3] https://www.irs.gov/pub/irs-drop/n-15-62.pdf

[4] http://www.top1000funds.com/news/2015/05/22/calpers-gives-its-managers-esg-ultimatum/

[5] http://www.pionline.com/article/20160404/PRINT/304049997/esg-integration-on-rise-but-issues-remain

Content prepared for US subscribers, but available to interested subscribers of other regions.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.

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