ESG: Sustainable Investing Ecosystem

The Birth of Green Swan

Amid debate on whether the pandemic should be classified as a black swan or white swan event, there is a rising awareness for green swan events and a strong tailwind for sustainable financing. Propelled by the green recovery plans post-pandemic and commitment to the Paris Agreement, there is a constituent demand to speed the transmission towards a low-emission economy. Furthermore, it is accelerated by the perceived opportunities of attractive returns and evolving regulatory bodies and landscape harmonizing ESG disclosures.

Sustainable Investing Ecosystem

According to the GSIR 2020 Report, global sustainable and responsible investments (SRI) surged to USD 35.3 trillion, representing 35% of all professionally managed assets across the regions covered.

Shown in the diagram above, there is a shift in paradigm from one end of the finance first and pure commercial spectrum towards a balance between impact and finance approach. This growing popularity of value-driven investing inclusive of ethical considerations and social values has called for the need for a common language - encompassing industry terms to facilitate communication and discussion among all relevant stakeholders. The three terms often used interchangeably include Environmental, Social, and Governance (ESG), Socially Responsible Investing (SRI) and Impact Investing. While these terms may be perceived as synonymous, this is a misconception as they described three different styles in the sustainable investing ecosystem.

SRI: Socially Responsible Investing

Before ESG and impact investing came into the picture, SRI had its roots traced back to the 1900s. Its earliest antecedents in religious groups date back to as early as 1500 BC. SRI is an investing strategy that considers both financial return and investment's alignment with acceptable social values. Historically, the modern era of SRI strategy was once popularized by John Wesley, the founder of the Methodist movement, which advocates avoidance of "sin" stocks". These stocks are essentially investments that are perceived as profiting at the expense of others well-being. For instance, "sin industries" such as tobacco, liquor and gambling. These practices then evolved into other forms, such as investments championing civil rights and divestment of South African operations to end the racist system of apartheid. All of which led to the creation of SRI mutual funds and its traction as an investing approach, resulting in the launch of Domini 400 Social Index as a benchmark to measure the performance of screened investments - which represents 400 large-cap U.S. corporations selected based on a range of social and environmental criteria. Presently, this index is known as MSCI KLD 400 Social Index, consisting of companies with high ESG ratings.

  • Types of SRI Strategy & Vehicles

There are several approaches for investors to undertake SRI strategy; they refer to methodologies used to narrow investments based on specific ethical guidelines depending on investors' preferences and social values. These approaches could mainly be segmented into three classifications - Negative Screening, Positive Investing and Community Investing.

Negative Screening is a technique used to screen companies' practices and offered products/services to filter out investments that do not align with one's principles. This is the opposite of Positive Investing, where investors seek companies with good practices which adhere to one's principles and values. To illustrate the differences between the two, one can think of investors avoiding companies with a history of bribery or corruption as Negative Screening - while investors looking for companies actively contributing to a positive environment as a positive investment. On the other hand, community investing is a more specific approach that invests in projects that uplift the economy of local communities and create opportunities in the ecosystem.

SRI is commonly used in public markets, accessible primarily in the form of mutual funds and ETFs. Other investment vehicles such as community investments and microfinance are also available.

ESG: Environmental, Social, Governance Risk Factors

Contrary to popular belief, ESG is not just an extension of SRI but refers to a framework used as part of the investment assessment process. ESG factors are measured in metrics to identify and analyse risks and opportunities, which are not accounted for in a traditional financial accounting framework. They are classified into three broad categories:

  • Environmental: considerations on the company's role in conserving nature, factoring its climate change strategy, biodiversity, energy efficiency, carbon intensity and essentially natural resource conservation. For instance, metrics in environmental criteria will consider data on carbon emissions, use of renewable energy sources or water stress levels produced.

  • Social: take account of relationships with various stakeholders such as employees, suppliers, customers and communities. This aims to measure equal and fair opportunities, health and safety, human rights, products responsibility and overall social values of a company. Examples include data on human capital and labour standards.

  • Governance: assuring trust in the system regulating the company's operations to ensure complete accountability and transparency - paying regard to data on business ethics, compliance and audit, statistics on company board, management team and involvement in corruption or illegal practices.

ESG Ecosystem & Landscape

Far from the current accounting standards landscape, sustainability reporting standards are still fragmented. This is due to having many standard setters, ratings and rankings providers - while principles exist in the market with ESG data spread across multiple reports. This is a considerable barrier, considering that ESG factors are measured with the primary objective of financial performance.

It translates monitored risks and opportunities into strategic planning and risk management to assess financial impacts in the short and long run. With increased regulatory scrutiny over greenwashing, it is becoming necessary for global regulators to harmonize sustainability reporting standards and ensure accountability in ESG-labelled investment products. This is paramount to put an end to the concerns that ESG assets are in fact "greenwashed" or, in other words, misleading to satisfy investors' attraction. ESG investing is more often used in public markets, with private markets starting to enter the landscape.

Impact Investing

Among the three terms, impact investing is the most recent concept coined. It is considered a subset of SRI. Unlike ESG, it depicts more of a standalone investment strategy with a targeted type of investment. Like ESG, impact investments have their own sets of metrics to measure to achieve specific impact themes. While ESG is a framework to identify non-financial risks and opportunities to assess the material impact on financial performance - impact investing metrics aim to directly measure positive outcomes in the environment and society. This represents the impact-finance parity position as opposed to a single and final focus on investments financial performance. Unlike SRI and ESG, which are primarily accessible to all investors through the public market, impact investing is more restrictive and mainly conducted on private markets - through private debt, private equity and venture capital funds.

  • Elements and characteristics of Impact Investing

Global Impact Investing Network (GIIN) defines impact investing with the following four key elements:

  • Intentionality: Its primary focus is on generating positive contributions to the environment and society. This strategy differs from ESG investing and SRI because it is driven directly by an investor's specific impact.

  • Financial Returns: Unlike the purely impact or philanthropy model, impact investments consider financial return across a wide range of below-market-rate to risk-adjusted market rates.

  • Range of Asset Classes: With its wide range of financial returns, impact investing could come in the form of different asset classes such as grant support in one end of the below-market investments and private equity in the other end of the market-rate investments.

  • Impact Measurement: Starting from setting goals and expectations mapped out on impact categories and themes or the basis of UN-SDG. Investors could then define strategies to achieve the relevant goals set per the impact theme. Once strategies are developed, metrics and targets are used as a performance proxy and reviewed to manage performance. In addition, it considers relevant information, its implication on risks, returns and other impacts to facilitate investment decision-making.

In facilitating these four key elements, core characteristics are introduced to complement these four elements.

  • Intentionally contribute to positive social and environmental impact: investment thesis with transparency in its intention and defined strategies to achieve goals and outcomes set.

  • Use of evidence and impact data in investment design: Measurement of quantitative and qualitative data, often depicted in metrics as indicators of performance set against a target.

  • Manage impact performance: Incorporate feedback loops in the entire investment cycle in leveraging evidence and data insights to identify relevant risks and develop mitigation plans.

  • Contribute to the growth of impact investing: A more interconnected network to enable effective impact investments through collaboration in sharing and discussing impact investing practices.

Thank you to Marco Tarchoune and Shannen Davelyn Kosasih, for your in-depth analysis!

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