Celebrating London Climate Action Week, this article features as part of IFA Magazine’s editorial campaign throughout this week, which aims to highlight key issues, news and views in the field of climate action.
Written by Andrea Acimovic, ESG Specialist, Elston Consulting
In the investment universe, there is a long history of environmental, social and governance (ESG) issues being factored into decision-making frameworks.
Explicit ESG investment practices began in the 1960s, largely focusing on issues relating to ‘ethical’ considerations and often owing to the ethical or religious beliefs of an institutional client, such as a church or charity. For example exclusions could be made from a sector perspective – avoiding tobacco businesses, or from a regional perspective – excluding a country with a tainted political regime.
As time has progressed, the analytics and tools that guide ESG investing have become increasingly sophisticated, bringing companies’ ESG credentials into sharper focus, thereby equipping investors with a clearer view of the opportunities available to them.
That said, since the ratification of the UN’s Sustainable Development Goals in 2016, it has really only been in the past five or so years that more formally-defined measures have been rolled out and adopted by businesses, affording investors greater clarity in evaluating issuers’ ESG credentials, and enabling data and index providers to create ESG ratings.
These developments, combined with the growing requirements on fiduciaries, (including trustees, pension schemes and wealth managers) and governance committees (for providers and financial adviser firms) as well as other decision-makers to consider ESG-related risks as a core part of product governance considerations have prompted a proliferation of ESGaligned funds. Between 2015 and 2020, the number of ESG index funds and ETFs alone nearly doubled to approximately 4,000, on some estimates.
This sudden increase in demand for ESG-rated investment opportunities has found regulatory frameworks wanting and while the introduction of the Sustainable Finance Disclosure Regulation in 2021 – essentially Europe’s ESG investment rulebook – has gone some way to address this, as has the rollout of the EU Taxonomy for sustainable activities (a common classification system), the practice of greenwashing has been widespread.
In early 2022, Morningstar de-rated 1,200 funds (representing more than US$1trn of assets) that purported to carry ESG credentials but in fact went little or no way to materially address ESG concerns beyond mere ‘consideration.’
Inevitably, the work being undertaken by the various agencies involved will lead to the establishment of an ever more robust ESG ratings framework, fostering investor confidence and in turn underpinning demand for ESG investment opportunities.
Rather than simply screening out companies on the grounds of negative ESG contributions, investors should be able to seek out opportunities that sponsor active integration and impact.
Alongside actively-managed ESG funds, ESG-aligned ETFs and index funds are also enabling ESG investment to become more mainstream, providing investors with low-cost opportunities to access the market. In defiance of the commonly-held assumption that specialist funds imply higher fees, Morningstar research found that actively-managed ESG funds often have lower fees than their non-ESG counterparts.
The financial services industry has a role to play in achieving the transition to a low carbon economy, in line with the goals of the Paris Agreement, and low-cost, robustly-defined investment opportunities will play their part in enabling this.