Environmental and Social Governance (ESG): Introduction and History
Until late 1960s, sustainable investing mainly considered screening to avoid “sin industries”. Dated back to 18th century, some churches in the US prohibited investments in slavery, war and some other sin industries namely liquor, tobacco and gambling, some similar motivations to Islamic finance (please see page XX for more information on Islamic finance and sustainable investments). However, later last century, environmental and social concerns have been dominating the field of sustainable investments. Man made environmental disasters like Chernobyl and Deep Water Horizon Oil Rig Explosion in addition to the alarmingly increasing anthropogenic green house gas concentrations in the atmosphere drove the investors to monitor their risks. Major endowment funds, asset management companies and pension funds have started developing value based investment criteria while the suppliers introduced the idea of thematic investing to meet the demand. This first phase of the sustainable investment era can be named as “negative screening”.
Later in 1990s, in addition to excluding specific sectors from investments, some new investment products were developed to prioritize investing in companies with superior sustainability governance meaning sound environmental and social safeguards and risk mitigation mechanisms. This second phase of “positive screening” enforced companies to develop robust environmental and social governance (ESG) tools to display how they assess and mitigate their sustainability risks. It is seen that the focus of ESG for most of the companies is now mainly related to climate change risk management and there is a strong movement in the industry to integrate the ESG in not only “some” but in all investment decisions. In addition to that, those investors demanding pure environmental and social benefits helped the rise of a new investment field called as “impact investment”. Not only in the form of private equity but by using bonds, green debt instruments and other project finance tools, investors now aim at being involved with sustainable development.
A study by the Task Force 1 categorizes the sustainability taxonomy at three levels. At the first level, the study concludes that the difference between the terminology of “sustainable investing”, “responsible investing” or “impact investing” is nonmaterial, all by capturing the same idea of socially and environmentally concerned investments and gathers all of them under the roof of “Sustainable Investments”. At the second level, there are three fields of taxonomy practice. The field of ESG is considered not as part of an investment strategy but a regular investment practice. The screening methods or in other words strategies usually adopt two different but interrelated perspectives where positive screening is usually related to operating behaviour. As investors or financiers may create their own ESG evaluation systems, they may also receive data from third parties as the scores are usually not standardized but can be used for relative comparison of the industry peers. ESG based positive screening is sometimes called “best in class” but however it is called, the screening methods usually fall in the positive category.
Negative screening may sometimes refer to the exclusion of some companies from some investment portfolios due to their low ESG performance. Yet, the experience in the field that it usually means to a black or white investment policy to avoid investing in the companies based on “what they sell” i.e. tobacco, alcohol or weapons and recently of course fossil fuel producers or those that generate energy from fossil fuels. As expected, no matter what portfolios use –negative or positive screening- the outcome of notable risk identification is quite similar. For instance, excluding fossil fuel from a portfolio tend to improve the overall ESG performance of the portfolio by eliminating significant social and environmental risks.
Thematic methods or strategies aim at building portfolios from selected sectors, regions by strictly putting constraints to prevent some businesses from entering their universe. Some financiers have the strong opinion that such elimination will automatically help the sectors to outperform while mitigating the social and environmental risks. For instance, companies managing their GHG risks will eventually avoid some regulation risks and eventually by decreasing their manufacturing costs while traditional businesses will face significant loss not only due to regulation risks but increasing input cost and low efficiency.
According to the Responsible Investment Association of Canada, almost 80 percent of the portfolio managers consider ESG in their investment decisions.2 Afterall, ESG practice is now so common that there is no large-scale investment company that has not established some sort of ESG assessment mechanism. The report from the Task Force distinguishes the ESG practice from ESG strategy because they are not considered as the major driver in the investment criteria. While the successful integration of ESG should result in risk mitigation and identification of new opportunities for green business development, the engagement level of the companies for developing awareness in social and environmental risk management while evaluating and monitoring impact is essential.
Link 1 https://greenchipfinancial.com/wp-content/uploads/2016/09/Sustainable-Investment-Taxonomy-Report.pdf Link 2 https://www.newswire.ca/news-releases/canadian-responsible-investments-surpass-2-trillion-698391901.html