Five things to know about Responsible Investment

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February 2022
 

In order to understand how responsible a product is, it’s important to ask, what are the key points investors need to consider? Here, Kristina Church, BNY Mellon Investment Management’s head of responsible strategy, considers the changing responsible investment landscape and some of the key hurdles that exist for investors.

The world is undergoing a dramatic transformation that will require responsible allocation of capital to address pressing environmental and social challenges and deliver shared prosperity. As such, what follows are five important responsible investment (RI) factors that investors should consider.:

1. Definitions and a lack of standardization

In a world where one investor’s “responsible investment” (RI) can be another’s “sustainable investment,” widespread confusion reigns over the meaning of many RI terms. The fact that there are relatively few standardized definitions in terminology can lead not just to confusion but also a lack of rigor in the investment process. Such vagueness also could, in some cases, inadvertently open the door to potential “greenwashing”—whereby companies convey a false impression or provide misleading information about the strength of their environmental credentials.1

On that point, the Organization for Economic Cooperation and Development is just one international body that has called for a common standard for environmental, social, and governance (ESG) definitions. Policymakers and regulators may ultimately need to make them mandatory. However, the creation of mandatory ESG standards has been patchy at best across the world, with some countries enacting legislation requiring public and private companies to disclose information on ESG issues. It would likely fall upon regulators such as the Securities and Exchange Commission (or similar regulatory equivalents) to police these. Yet most acknowledge this is unlikely to happen anytime soon, thereby, for the moment, placing the onus of research and due diligence on investors and financial professionals themselves.

Considering this, Church says: “Because there are so many definitions out there, what one investor understands as sustainable another may term as ESG integration —and this is just one example of how definitions can blur. There is a need to make sure every RI-related term is clearly defined so that investors can really know what they are getting with their responsible investment strategies.”

2. Quality of data

Conflicting data sources also can cloud the picture on responsible investment, and this remains a major challenge for financial professionals and investors alike. If then there is a lack of standardized data for key environmental and social factors, how can investors meaningfully assess company performance in this area? The growth of the RI market has led to a proliferation of ESG-related data and ratings’ providers, but because most company reporting on key ESG factors is currently voluntary, many investors are getting a fragmented and inconsistent view.2

Myriad methodologies and data aggregation can also create conflicting ESG ratings and rankings—blurring the picture on exactly what an investor is getting into and, in some cases, making meaningful performance comparison extremely difficult.

According to Church: “Quality of data and availability of data are extremely important considerations. Discrepancy between third-party data providers and the increasing need for forward-looking data—which by its nature tends to be subjective—remains problematic. There is an urgent need for global alignment among all key stakeholders—including governments, regulators, asset managers, and corporations—to develop mandatory commitments for reporting of key ESG issues.

“The mandatory reporting of consistent, standardized, high-quality data could prove a critical factor in enabling investors to have confidence in the products and investment vehicles in which they are investing. In the meantime, effective stewardship [including, where applicable, active engagement and proxy voting] can help encourage greater corporate disclosure.”

3. E, S or G?

Tackling global warming and efforts to reduce carbon emissions to align with a net-zero world, and “nature-positive” investing, remain critical aspects of the “E” in ESG. However, social aspects such as workplace equality and boardroom gender diversity likely can improve corporate decision making and, in some cases, financial performance.

In a world shaken by the impacts of the Covid-19 pandemic, companies which can demonstrate good governance, are committed to strong environmental stewardship, and which are socially progressive are increasingly being recognized as more attractive investments than those which ignore or pay mere lip service to responsible commitments.

Church says: “In particular, the pandemic has brought the social aspect to the fore and raised the importance of the need for equality and a ‘just transition’ for all. This trend can only grow in importance as investors become more aware of the intrinsic benefits and value social improvements can bring.

“There are still considerable complexities around measuring and reporting social considerations within an investment strategy, particularly as social values can differ greatly by geography, but we expect 2022 to be the year when regulators focus on the need to clearly define a more meaningful set of social classifications or taxonomy.”

4. Geography matters

Global investors committed to investing responsibly face the added headache that not all markets are as advanced or aligned as others in addressing ESG and wider RI concerns. Again, common standards do not exist across all markets, and there is a plethora of regulatory frameworks across geographies.

European countries, particularly those in northern Europe, are widely recognized for their longstanding commitment to responsible investment and sophistication in this area. The regulatory framework for responsible investment is also most clearly defined in the European Union and, increasingly, in the United Kingdom. However, emerging markets, and even developed countries such as the United States have yet to lay out their full ESG frameworks for investors.

The United Kingdom ranks only 15th on rating specialist Morningstar’s Sustainability Atlas, which uses the constituents of Morningstar country indexes to examine the sustainability profiles of 48 country-specific equity markets. Several big Asian markets score poorly on sustainability in this system, with Japan, China, and South Korea all further down the list.

Some of the weakest RI performers, based on this Atlas analysis, include several Middle Eastern, Latin American, and Eastern European emerging markets, including Russia and Brazil.3 Yet the Morningstar Sustainability Atlas is just one measure among many, and investors should be aware that different responsible investment standards and adoption can and do vary widely across markets. Church adds that investor demand and the regulatory backdrop is also evolving extremely rapidly.

Church says: “Geographic divergence across markets can present some significant investment challenges as to what RI means in regions such as Europe versus the US or Asia and which can vary widely. What is deemed a social value or norm in one market may be regarded completely differently in another market, and investors need to be very alert to this. “You can’t simply impose one market’s standards on another. The ideal scenario would be to have a single international standard for sustainability, such as that currently being developed by the International Sustainability Standards Boards. However, taking a one-size investment approach across markets is unlikely to work in the near term.”

5. Transitioning companies: investment friend or foe?

As the carbon transition evolves, recent research suggests many companies that raise finance in the global capital markets are planning to start transitioning away from environmentally and socially challenged business models within the next five years.4

Yet without standardized global regulation in this field, how can investors gauge such progress? With a dearth of reliable benchmarks, some investors continue to avoid carbon-intensive sectors and companies, even though these players may be committed to reducing emissions and making significant progress toward net zero alignment.

As just one example, several fossil fuel-dependent energy companies have stepped up investment in clean, renewable energy sources in recent years, to reduce their carbon output and help meet global emissions targets. Should these companies be rewarded for their efforts to improve instead of being shunned by some investors?

According to Church: “Many investors instinctively feel a company which is in transition cannot be labeled as sustainable. To date, many RI flows have crowded into companies which already have the highest environmental or social ratings—but this can create overcrowding risk and thus potentially direct flows away from sectors which most urgently need to transition.

“In future, we expect to see greater focus on identifying companies that aren’t best-in-class today, but which are transitioning to align with a lower carbon world or are putting in place policies to ensure a better impact on the environment and society. For the wider economy to globally transition, those are exactly the type of companies that have the most urgent need for capital.

“That said, we do need to make sure they have an effective and clearly-defined transition trajectory and a sustainable, and profitable, business model. This is where responsible stewardship of capital will play a key role. Effecting change will often require engagement to influence change on issues which are vital to long-term value creation,” she concludes.

1 “Which countries lead on ESG?” Morningstar, April 22, 2021.

2 Currently, Responsible Investment terminology is defined differently by respected industry bodies such as the Principles for Responsible Investing (PRI), Global Sustainable Investment Alliance (GSIA), Financial Conduct Authority (FCA), and the CFA Institute.

3 “Lack of standardized ESG data may hide material risks, OECD says,” S&P Global Market Intelligence, October 2, 2020.

4 HSBC’s Sustainable Financing and Investing Survey 2021, September 15, 2021.

 

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Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.

This material has been provided for informational purposes only and should not be construed as tax advice, investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change.

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