ESG – Three guiding principles
As our approach to sustainable investing has evolved, we have distilled three key principles that guide our thinking on investing based on environmental, social and governance (ESG) considerations:
1. Assessment of ESG factors is an integral part of a robust investment process, rather than a distinct investment discipline.
At the heart of this is our firm belief that incorporating ESG factors into the investment process equips investors with a fuller picture of the risks and opportunities faced by businesses and governments. This better positions investors to evaluate the risks and opportunities associated with any investment. Incorporating ESG factors into the investment process broadens the scope of information considered, contributing additional insights that improve investment decisions.
At the current nascent stage of ESG integration by the professional investment community, long- term opportunities likely exist due to mispricing of various ESG factors. For instance, the vast majority (87%) of respondents to a recent global survey of investment professionals by members of the Global Sustainable Investment Alliance (GSIA) published in December 2019 do not believe that markets are consistently and correctly pricing climate risks into company and sector valuations.
2. Consideration of ESG factors focuses attention on long term, risk-adjusted investment returns.
Focusing on long term, risk-adjusted investment returns is a key tenet of wealth management.
As stewards of capital for clients who are investing to meet long term financial goals (such as their children’s education and a secure future for their family), we aim to position our clients’ portfolios to benefit from persistent, long term trends, prioritising these over short term headline returns that may be at risk as the costs of poor practices manifest themselves over time. Businesses that manage for the long term consider how they affect the environment and how they treat their stakeholders, including regulators, employees, contractors and suppliers. Such firms are better positioned to generate sustainable returns to shareholders and bondholders over time.
3. ESG investing is not a simple, “yes or no” decision; investors should choose the approach that aligns best with their goals and preferences.
It is critical to understand at the outset that there are a multitude of approaches to sustainable investing. The investment approach ultimately needs to be aligned with investors’ goals and preferences – in the same way that investors’ risk appetite and long term financial goals should guide their optimal portfolio asset mix. Put simply, there is no one-size ESG approach that fits all investors and selecting the correct approach depends on proper identification of individual goals and preferences. Exhibit 1 shows a broad categorisation of the many approaches to ESG investing in practice today.
Importantly, investors who have little interest in investing directly in social enterprises where ESG goals are explicitly prioritised above profits (at the impact investing or philanthropy end of the spectrum shown in Exhibit 1) would still benefit from thoughtful Integration of ESG factors into their investment decisions.
ESG data captures factors important for valuations (such as business reputation) that are not usually reported and provide insights that are not readily observable using conventional financial metrics. Incorporating these considerations into investment analysis supports better investment decision-making by identifying additional sources of risk and return from key non-financial factors.
As higher-quality ESG metrics and industry standards are developed and more ESG-focused products are introduced, we see increasingly greater opportunities for investors to align their portfolios more closely with their own sustainability preferences and goals.
ESG at work – our approach
We adopt a consistent approach to ESG integration that allows our investment specialists, research analysts and portfolio managers to blend the sustainability insights drawn from quantitative ESG data with qualitative analysis and to use their professional judgement to assign suitable weights to this information as they do with conventional financial metrics.
Our approach to sustainable investing is forward-looking and transition-based. When evaluating investment opportunities, we take into account not just the current and past ESG profile of a business or government, but our assessment of its future trajectory.
This means that we look at both current ESG leaders and ESG laggards based on their adoption of clear sustainability-linked goals and meaningful progress towards those goals.
In short, we do not automatically exclude investment opportunities in businesses that are current laggards from an ESG perspective – as long as we assess that these enterprises are likely to adapt successfully to evolving consumer preferences and regulations associated with sustainable economic development paths.
Our approach aligns closely with a well-established concept in conventional investing –that the beaten-down stock or bond of a company that has started on the path to recovery often presents an excellent investment opportunity for patient capital.
This nuanced approach is particularly relevant for investors seeking opportunities in large parts of Asia and other global emerging markets – our Bank’s core areas of expertise – where ESG-focused regulation, data collection and disclosures remain in the early stages.
ESG in Equities
Businesses today are faced with a wide range of ESG factors that present both risks and opportunities that in turn affect equity valuations. Given the idiosyncrasies inherent to each sector, the influence of different ESG factors varies substantially across different sectors. Each of these ESG factors also needs to be analysed through the lens of specific business segments and geographies that individual companies have exposure to.
For instance, regulatory and reputational risks related to carbon emissions, energy consumption, water intensity, pollution and broader environmental degradation are most relevant for traditionally emissions-intensive industries such as fossil fuel production (oil and gas, thermal coal), mining, power generation, autos, and cement and chemicals manufacturing.
Similarly, risks related to sustainable land use, labour practices, employee health and safety, product liability and ethical sourcing tend to be more significant for industries such as agriculture, food production, luxury goods, and garment manufacturing.
Investors should also examine the policies and actions of companies to manage or mitigate their most important risk factors. The time horizon associated with the potential manifestation of risk factors is another key consideration.
Our analysts and portfolio managers today already take these factors into consideration. These are reflected in the assumptions used for financial forecasts, discount rates (when employing a discounted cash flow approach for valuation), and in our qualitative comments in our assessment of companies.
ESG in Fixed Income
In fixed income, our focus on emerging markets presents significant challenges to comprehensive ESG integration. First, a majority of emerging-market countries are at the nascent stage of their ESG journey compared to their developed market counterparts. This in turn means that ESG-focused regulation remains substandard, while ESG disclosures are limited and generally inconsistent across bond issuers. Corporate governance risks, in particular, remain prevalent due to a high number of privately held issuers with limited visibility.
Despite the current laggard position, progress is being made with a deeper focus on ESG factors and increase in awareness and conversations on the topic. Rating agencies, too, are incorporating ESG into their credit ratings. In 2019, Moody’s cited ESG risks as a material credit consideration in one-third of its private sector rating actions, with negative actions of 19% outweighing the 12% positive actions.
We believe investors should take a staged approach to incorporating ESG into their fixed income portfolios. Given the current limitations, an exclusionary approach would be particularly restrictive in fixed income. As such, we suggest that investors keen to increase their portfolio tilt into sustainability look to invest in companies that are superior within their peer group for ESG factors rather than outright exclusion of particular sectors or countries.
Within our current framework, ESG factors flow through key credit considerations and throughout our assessment of credit quality of an issuer. These are considered in our analysis of macro-economic, industry, sector and financial factors. We also highlight relevant risk factors in our communications; paying attention to these can help clients circumvent areas of high risk within their fixed income portfolios. Governance considerations including leadership quality, political stability and the strength of key public institutions and regulators have long been part of our assessment of investments in emerging markets credit.
The path forward
Recent deadly events have highlighted the need for increased action to guard against long-term sustainability risks for businesses and society as a whole. The Covid-19 pandemic sweeping across the world today has exposed the deepening inequality in wealth, living conditions and access to social security, healthcare and daily necessities even in developed economies. The ensuing shutdown of large swathes of the global economy has also resulted in significant operational risks for companies. For many businesses, the integrity and resilience of their supply chains, and the quality of their employee relations and crisis management have suddenly come into sharp focus like never before.
We see the crisis accelerating emerging trends in ESG and we expect the heightened focus on businesses’ environmental and social impact to persist long after the crisis abates. We hope the principles outlined in this paper will help our clients to develop a better understanding of their own ESG views, and to ultimately align their investments more closely with those views.
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Version: March 2020